What Needs Re-thinking in Macroeconomics?

The current financial crisis is the latest example of an unanticipated change that had a major effect on economies. We analyse some weaknesses in current economic analyses and modelling given the failure of most economists to anticipate this crisis. A key difficulty lies in the emphasis on ‘deep parameters of tastes and technology’ in economic theories of intertemporal optimisation, questionable both from sudden changes and on derivations requiring rational expectations. When unanticipated breaks occur, it cannot be proved that conditional expectations based on the current distribution are minimum mean-square error predictors, and the law of iterated expectations then does not apply.

Policy Implications

  • Modern economies are often buffeted by surprise events.
  • Macroeconomic policy models must adapt to unanticipated changes.
  • ‘Rational expectations’ are not necessarily rational in the presence of unanticipated change.
  • Currently popular macroeconomic models then use biased predictors and embody inappropriate intertemporal expectations.
  • New approaches to macroeconomic analyses and empirical modelling must be adopted.
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