Existing strategies for econometric analysis related to macroeconomics are subject to a number of serious objections, some recently formulated, some old. These objections are summarized in this paper, and it is argued that taken together they make it unlikely that macroeconomic models are in fact over identified, as the existing statistical theory usually assumes. The implications of this conclusion are explored, and an example of econometric work in a non-standard style, taking account of the objections to the standard style, is presented. THE STUDY OF THE BUSINESS cycle, fluctuations in aggregate measures of economic activity and prices over periods from one to ten years or so, constitutes or motivates a large part of what we call macroeconomics. Most economists would agree that there are many macroeconomic variables whose cyclical fluctuations are of interest, and would agree further that fluctuations in these series are interrelated. It would seem to follow almost tautologically that statistical models involving large numbers of macroeconomic variables ought to be the arena within which macroeconomic theories confront reality and thereby each other. Instead, though large-scale statistical macroeconomic models exist and are by some criteria successful, a deep vein of skepticism about the value of these models runs through that part of the economics profession not actively engaged in constructing or using them. It is still rare for empirical research in macroeconomics to be planned and executed within the framework of one of the large models. In this lecture I intend to discuss some aspects of this situation, attempting both to offer some explanations and to suggest some means for improvement. I will argue that the style in which their builders construct claims for a connection between these models and reality-the style in which "identification" is achieved for these models-is inappropriate, to the point at which claims for identification in these models cannot be taken seriously. This is a venerable assertion; and there are some good old reasons for believing it;2 but there are also some reasons which have been more recently put forth. After developing the conclusion that the identification claimed for existing large-scale models is incredible, I will discuss what ought to be done in consequence. The line of argument is: large-scale models do perform useful forecasting and policy-analysis functions despite their incredible identification; the restrictions imposed in the usual style of identification are neither essential to constructing a model which can perform these functions nor innocuous; an alternative style of identification is available and practical. Finally we will look at some empirical work based on an alternative style of macroeconometrics. A six-variable dynamic system is estimated without using 1 Research for this paper was supported by NSF Grant Soc-76-02482. Lars Hansen executed the computations. The paper has benefited from comments by many people, especially Thomas J. Sargent

/pdf/macroeconomics-and-reality-3v6kkpl8jz.pdf

Macroeconomics and reality

This paper shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts.

/pdf/bank-runs-deposit-insurance-and-liquidity-5acmze0roa.pdf

Bank Runs, Deposit Insurance, and Liquidity

Staggered prices in a utility-maximizing framework

http://dklevine.com/archive/refs41401.pdf

THE EQUITY PREMIUM A Puzzle

Convergence of Probability Measures. By P. Billingsley. Chichester, Sussex, Wiley, 1968. xii, 253 p. 9 1/4“. 117s.

Convergence of Probability Measures

Alternative monetary policies are analyzed in an ad hoc macroeconomic model in which the public's expectations about prices are rational. The ad hoc model is one in which there is long-run neutrality, since it incorporates the aggregate supply schedule proposed by Lucas. Following Poole, the paper studies whether pegging the interest rate or pegging the money supply period by period minimizes an ad hoc quadratic loss function. It turns out that the probility distribution of output--dispersion as well as mean--is independent of the particular deterministic money supply rule in effect, and that under an interest rate rule the price level is indeterminate.

https://www.jstor.org/stable/pdfplus/1830921.pdf

"Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule

In his presidential address to the American Economic Association (AEA), Milton Friedman (1968) warned not to expect too much from monetary policy. In particular, Friedman argued that monetary policy could not permanently influence the levels of real output, unemployment, or real rates of return on securities. However, Friedman did assert that a monetary authority could exert substantial control over the inflation rate, especially in the long run. The purpose of this paper is to argue that, even in an economy that satisfies monetarist assumptions, if monetary policy is interpreted as open market operations, then Friedman’s list of the things that monetary policy cannot permanently control may have to be expanded to include inflation.

/pdf/some-unpleasant-monetarist-arithmetic-14tdtedo1q.pdf

Some Unpleasant Monetarist Arithmetic

Rational expectations and the theory of economic policy

A modigliani-miller theorem for open-market operations

The argument, elaborated most convincingly by Milton Friedman (1962) is familiar to most if not all monetary economists. A fractional-reserve banking industry is "inherently unstable." That is what the U.S. Congress acknowledged, if somewhat belatedly, when in 1913 it created a lender of last resort, the Federal Reserve System. But the system, once hailed by Irving Fisher as the guarantor of perpetual prosperity, was a terrible disappointment. It failed miserably the test posed by the depression of 1929 (or had the System done what it was supposed to do, what would have been the recession of 1929). There was an epidemic of bank failures in 1930-31. And in 1932-33 there was another epidemic, even more serious, which culminated in the banking holiday of 1933. So the Congress, having discovered that the industry it thought it had made panic proof was still panic prone, established another agency of government-the Federal Deposit Insurance Corporation, to insure certain of the liabilities of commercial banks operating within U.S. boundaries. And if it did not do as well by U.S. citizens as it might have, what it did was extremely helpful. To quote Friedman: ". . . federal deposit insurance has performed a signal service in rendering the banking system panic-proof . . .' (1959, p. 38). In his view, the In this paper we examine the equilibrium of the banking industry under various regulatory schemes. There are several critical assumptions: There are complete contingent-claims markets; the banking industry is a monopoly supplier of deposit services, but is otherwise "'small"; banks are limited-liability corporations and are subject to bankruptcy reorganization costs. Among the more important conclusions are the following: (1) Absent deposit insurance and regulation, bankruptcy does not occur; (2) under an FDIC-type insurance scheme, the banking industry holds as risky a portfolio as regulations allow; and (3) a capital requirement, by itself, does nothing to forestall bankruptcy.

/pdf/deposit-insurance-and-bank-regulation-a-partial-equilibrium-4zx9f37jw5.pdf

Neil Wallace

Papers

"Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule

Some Unpleasant Monetarist Arithmetic

Rational expectations and the theory of economic policy

A modigliani-miller theorem for open-market operations

Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition