Economic modeling why the standard model survives bad performance.

• Author: Gjerstad, Steven D.
• Position: Etceteras ... - Essay

Many economists are reluctant to abandon their favored model of the general economy: the dynamic stochastic general equilibrium (DSGE) model. (1) This model is favored because most of the time if the economy departs from its accustomed longterm growth path, it returns to that path in a short-enough time to argue against abandoning the model. In thirteen of the past fifteen recessions-87 percent of the cases-the U.S. economy has avoided getting stuck in severe underperformance.

The top line in figure 1 plots the logarithm of real (inflation-adjusted) gross domestic product (GDP) over the past ninety-one years, from 1924 through the first quarter of 2015. There have been only two great peacetime declines in which economic growth fell substantially below its long-term trend: the decline of 1929-40 and the current decline beginning in 2007.

GDP's typically close adherence to its trend is attributable primarily to households' consumption spending for nondurable goods and services (C). Roughly twothirds of GDP, C is the heavy flywheel that almost always maintains the momentum and stability of economic output and masks the inability of the DSGE model to capture instabilities arising from other components of GDP. Notice that in figure 1 GDP has some ripples in it, whereas C has almost none.

What is unique and special about C that normally imparts its stabilizing inertia to return GDP to its long-term trend?

Households' consumption is essentially composed of items that are perishable and not retraded, such as haircuts, hotel space, and hamburgers. You buy them for their immediate consumption value; consumers specialize as buyers and are well practiced in that role, as are producers in their role as sellers of these goods and services. Laboratory experiments corroborate such markets' ability to quickly converge to equilibrium outcomes. These defining features are so fundamental that you probably never think about their deeper significance. Neither do economists and policy makers. As a consequence, and critical to understanding models such as DSGE, there is never any conflict between the immediate consumption value of an item and its resale price. Resale is not an option and does not enter your thoughts or your market behavior.

Economic instability derives from the components of final demand that are durable and retraded. In sharp contrast with households' consumption, which is smooth, consumer spending on durable goods (D) plus that most lasting of...