“Policy models cannot be expected to have the same tight structure as theory models. […] Different classes of macro models are needed for different tasks.”
During the Annual Research Conference organised by the ECB on the 25th and 26th of September 2017, Vítor Constâncio, Vice-President of the ECB, held the opening speech.
The meeting, at its second edition, it’s used by the ECB to stress its strong connection with the research environment, since “it contributes to shape the intellectual framework that we use to understand economic developments and to take policy decisions”.
Moreover, interesting insights were provided on how the ECB is currently and will take decisions regarding monetary policies.
Mr. Constâncio opened by saying, with the words of Lawrence J. Christiano, economic consultant at the Federal Reserve bank of Minneapolis, that the Great Recession has been a “macroeconomics earthquake” to which the field is still adjusting.
He stressed a series of important points that were ignored by mainstream economics, such as the importance of stabilisation policies, the heterogeneity of agents and its connection with behavioural economics, an uprising branch since the Great recession, and the possible existence of multiple equilibria.
The previous points helped Mr. Constâncio to introduce a more general idea, and guideline for further modelling, that there exists a need for a variety of models “to understand, forecast and analyse the economy and the policies necessary to address its shortcomings”, as pointed out by Olivier Blanchard, professor and Senior Fellow at the Peterson Institute for International Economics and previous chief economist at the International Monetary Fund.
DSGE models and introduction of the ECB-MC model.
With this underlying renovation in macroeconomics, the ECB had to choose how to proceed for what concerns which model to use for addressing policies.
As reported by Mr. Constâncio, one way could have been to remain within the DGSE framework.
For those of you who are not experts in macroeconomics, a brief but handful refresher is provided by Mr. Blanchard himself. For over ten years, DSGE models have been the key tool used for policy analysis in many central banks, among which the ECB. They often reproduce the dynamic effects of changes in monetary policy interest rates that are observed in identified Vector Autoregression Models (VARs.), a more exstensive version of an AR. This is also the case for the New Area-Wide Model, developed in the Directorate General Research.
However, Mr. Constâncio provided reasons why remaining within the DGSE framework may not be useful and efficient, from both a theoretical and a policy analysis point of view. Specifically, DSGE models do not always provide credible explanations for observed economic developments, for example technology shocks. Furthermore, DSGE models are quite static and not flexible to a new policy environment or more generally to an incorporation of new features, often limiting its interpretational power.
This led to the design of the new ECB multi-country model: ECB-MC.
Following the words of Mr. Blanchard on the difference in structure between theory and policy models, the new ECB-MC model was designed according to two guidelines: the inclusion of financial frictions and other financial channels, previously omitted, via which monetary policies shocks can be transmitted; the adoption of a more flexible, semi-structural, empirically driven approach. A crucial element according to Mr. Constâncio is that policy analysis models can be adapted fast enough to address newly emerging questions. This view appears clearly in the development of the ECB-MC model.
New challenges and ECB-MC refinements
The development of the ECB-MC model is led by the Directorate General Research and is a joint effort of economists from a wide-range of policy areas inside the ECB, colleagues from national central banks and academic consultants. Mr. Constâncio stated that it will soon be part of the ECB toolkit. However, he also added that further refinements will prove to be necessary in the future, for the model to continue to be a valuable policy tool.
Mr. Constâncio addressed four areas of interest.
Particularly interesting is the first area addressed, that is the micro foundations of aggregate consumption. Standard DSGE framework relies on ‘rational expectations permanent income’ model of consumption and on ‘representative-agent model’. Both of them do not capture the consumer specific risk, technically called idiosyncratic risk, the fixed uncertainty related to income and both credit and liquidity constraints. However, the ECB-MC marks an improvement, since consumption aggregate function is explicitly affected by consumers’ wealth holdings.
The second area deals with the modelling of expectations. The ECB-MC again marks an improvement, since the model can be simulated either in “a more consistent manner”, which I interpret as a “classic/rational manner”, or under the assumption of bounded rationality of agents.
The third area addressed has to do with the nexus between inflation, wages and the real economy. During the Great Recessions and in more recent years, talks have been held on a missing “piece of the puzzle” regarding the dynamics of inflation. According to Mr. Constâncio, the nature of the ECB-MC makes it ill-equipped to address this missing mechanism, but it would be a problem for any model for the very structural nature of the problem.
The fourth and final area regards the macro-financial channels, for the most part being already incorporated in the ECB-MC.
Vítor Constâncio concluded by stressing again the importance of having different models, and not to rely on one. He added that for developing such a variety, the academic research plays a crucial role.
The fact that exists such a strong connection with the institution and the academia is reassuring. Besides, even in its highest tiers, also the ECB is embracing the renovative heterogeneous stream flowing especially in macroeconomics,which is even more reassuring.