Do DGSE models suck?

DGSE stands for Dynamic General Stochastic Equilibrium, basically it’s very complicated models that try to explain what’s going on in the economy. These models are nowadays widely used in policy relevant institutions such as the central banks. For several years, their reliability has however been  put into question, notably for their lack of forecast of the last financial crisis. This article is the first of a series which will talk about the relevance of DGSE models in modern macroeconomics. As you will see, opinions with regards to DGSE models are extremely heterogeneous, I will thus try to summarize the different points of views and highlight the different arguments.

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The liquidity trap and the failure of monetary policy

We are in a depression. This means that we need some sort of stimulus so that we could escape from this bad period. This help can come from two major actors, the governments or the central banks. In this article, we will focus on the latter one.

Historically, central banks have helped to restore economic growth by, among other things, printing money. In reality, central banks lend money to banks hoping that those funds will be used for investments that benefit the real economy. If we invest more, new businesses are created, already existing businesses expand, work demand increases and everybody is happy because the economy is doing well again. As I mentioned it, this kind of stimulus worked quite well in the past.

However, since the last financial crisis, this kind of policy doesn’t seem to work so well anymore. When a central bank prints money, it lowers the interest rates.

Why is that? It is a bit more technical but basically, by printing money, the central banks increased the total amount of money in the economy (what a news!). This means that money is worth less than before (via the law of offer and demand). Holding bonds become therefore less interesting for a simple reason. The value of the bond is already fixed. Say, you will get 1000$ in ten years. Since money is worth less, this is less profitable than it was when money was more “valuable”. The effective interest rate of holding bonds is therefore lower than it was. Since all interest rates are positively correlated. The overall interest rates decrease.

Having debts is therefore less costly than it was. Say that interest rates on debt is 2%. You have a project that can get you a return of 4% in the good case and a return of 1% in the bad case. You might not do this investment because considered too risky or because there is just too much uncertainty. However now imagine that the interest rates have decreased to 0,5% following a monetary policy. With low interest rates (i.e. financing project is relatively cheap), you cannot lose money with your project because the return of your project is in either case higher that what you have to pay to get the funds. This encourages economic agents to invest more in new projects from which the economy will benefit. 

The problem we have today is that the interest rates are already very low (and investment too, because of high uncertainty). Printing money is therefore way less efficient since it cannot positively stimulate the investment and the economy via a decrease in the interest rates. Interests are so low that they can’t be lowered and this is called the zero lower bound.

To summarise, central banks print money in order to decrease interest rates and therefore increase investment activities. However, interest rates nowadays are so low that they cannot be decreased. We are in a liquidity trap where printing money does not stimulate the economy anymore as it used to.

For many years, economists believed that we would always be able to avoid depressions by using this kind of monetary stimulus. This had a serious consequence because there has been very little discussion in the past yearsabout what to do when monetary policy is not enough. To some extent, policy makers are running out of solutions. However and on the bright side, there is an expanding mass of work that is done in order to come up with new ideas such as fiscal stimulus in order to put the economy back on track.