How Shocks Affect Markets: A Novel Dynamical Macroeconomic Model to Explain Adjustment of Markets and Equilibria

Muhammad Ashfaq  Ahmed; Nasreen  Nawaz

Open Access |

How Shocks Affect Markets: A Novel Dynamical Macroeconomic Model to Explain Adjustment of Markets and Equilibria

Muhammad Ashfaq Ahmed1, Nasreen Nawaz1*

1Directorate General of Revenue Analysis, Federal Board of Revenue, Islamabad, Pakistan

*Correspondence to: Nasreen Nawaz, PhD, Chief Federal Board of Revenue, Directorate General of Revenue Analysis, Federal Board of Revenue, Constitution Avenue, Islamabad, Pakistan; Email: nawaznas@msu.edu

DOI: 10.53964/mem.2024010

Abstract

Objective: Most macroeconomic models are based on representative agents with identical preferences for all consumers and production technology for all producers, i.e., an assumption too simplistic if not unrealistic to model the real world. Similarly, the models revolve around a general equilibrium for all markets which seldom exists in a dynamic and rapidly changing and evolving world where shocks keep happening too frequently to imagine all markets to stay put in an economy. There is a lack of robustness of macroeconomic models with respect to inflexible assumptions they are based on (including but not limited to specific structural forms for utility functions and production technology). This paper provides a foundation stone for a more realistic macroeconomic modeling based on practical behavior of economic agents with minimum number of assumptions without use of specific and complex structural forms as compared to those in the existing literature.

Methods: This paper captures an interaction of three markets, i.e., goods, labor, and capital. Dynamic optimization problems of agents in all three markets have been solved to find expressions regarding their individual decisions, which have been solved simultaneously to get a nonhomogeneous linear system of differential equations, for which conditions for a unique solution has been specified. Also, conditions regarding stability and existence of an equilibrium have been stipulated.

Results: It provides results which are robust to heterogeneous consumers and producers exhibiting bounded rationality. It models macroeconomy based on easily measurable empirical components. After estimating and substituting empirical parameter values in the system of differential equations and solving them, the response of three markets can be predicted. The model captures not only both initial and final sets of equilibria before and after shocks to all markets, rather it predicts the full adjustment path of all markets from initial to final equilibriums after various kinds of shocks happen to one or more markets.

Conclusions: Optimal policies, such as monetary policy, taxation, inflation control, employment, trade, remittances, etc., affecting one or more of the three markets subject to relevant constraints can be derived based on a system of differential equations. The methodology employed for three markets can be extended to n number of markets in an economy.

Keywords: macroeconomic modeling, heterogeneous agents, bounded rationality, equilibrium, disequilibrium, coordination

1 INTRODUCTION

Four important critiques of dynamic stochastic general equilibrium (DSGE) models from an agent-based computational economics (ACE) perspective revolve around heterogeneity, disequilibrium, complexity, and rationality. Modern DSGE models often answer one or more of these critiques. Although it is difficult to strictly classify and compare ACE models, it is possible to identify four major families of models within the macro-ACE literature. Some New Keynesian models incorporate insights of ACE models into DSGE; however, they do not incorporate local interaction and disequilibrium.

Most of macroeconomic models are based on representative agents with identical preferences for all consumers and production technology for all producers, i.e., an assumption too simplistic if not unrealistic to model the real world. Similarly, the models revolve around a general equilibrium for all markets which seldom exists in a dynamic and rapidly changing and evolving world where shocks keep happening too frequently to imagine all markets to stay put in an economy. The learning literature adopts two basic approaches to modelling boundedly rational expectations. The first is usually referred to as statistical learning, where agents are competent econometricians who make observations of the price, have some idea of the data generating process and estimate it using standard techniques. The second approach assumes that agents use simple heuristic forecasting rules. A general formulation that nests examples found in the literature is an adaptive expectations rule.

There is a lack of robustness of macroeconomic models with respect to inflexible assumptions they are based on (including but not limited to specific structural forms for utility functions and production technology). For example, if an assumption of homogeneous agents is relaxed in a DSGE model, it might break down instead of showing robustness with regard to the results it predicts. A model based on practical must be robust with regard to variations in agents' behaviors, especially, until their distribution in an economy stays the same. Secondly, a sound model must be based on measurable parameters to be empirically estimated and used practically with little discretion with practitioners.

This paper provides a foundation stone for a more realistic macroeconomic modeling based on practical behavior of economic agents with minimum number of assumptions without use of specific and complex structural forms as compared to those in the existing literature. It provides results which are robust to heterogeneous consumers and producers exhibiting bounded rationality; and equilibrium expressions as well as disequilibrium paths after shocks happen to various markets. It models macroeconomy based on easily measurable empirical components, such as slopes of supply and demand curves in various markets.

Gatti, Di Guilmi, Gaffeo et al.[1] criticizes reductionist approach of using a representative agent in macroeconomic models ignoring heterogenous preferences and endowments, including non-normal distributions and interactions between agents due to which DSGE models do not allow any room for emergent macroscopic patterns. Howitt’s[2] diagnosis is that macroeconomic theory has become distracted by its preoccupation with states of equilibrium, a preoccupation that inhibits analysis of a market economy's coordination mechanisms. Woodford[3] reconsiders familiar results in the theory of monetary and fiscal policy when one allows for departures from the hypothesis of rational expectations. Fagiolo and Roventini[4] presents a critical discussion of the theoretical, empirical and political-economy pitfalls of the DSGE-based approach to policy analysis. They suggest that a more fruitful research avenue should escape the strong theoretical requirements of New Neoclassical Synthesis (NNS) models (e.g., equilibrium, rationality, representative agent, etc.) and consider the economy as a complex evolving system, i.e., as an ecology populated by heterogenous agents, whose far-from-equilibrium interactions continuously change the structure of the system. Rogers[5] argues that new DSGE model is impossible to interpret or to be used as a basis for advice on monetary policy.

Among ACE models, Russo, Catalano, Gaffeo, Gallegati et al.[6] talks about various kinds of macroeconomic models historically used by economists and their empirical performance; and proposes a model for economy which consists of one sector with idiosyncratic R&D shocks at the firm level; firms' pricing strategies are boundedly rational, and evolve according to a specified heuristic. Deissenberg, Van Der Hoog and Dawid[7] describe the general structure of the economic model developed for EURACE and present the Flexible Large-scale Agent Modelling Environment. Gatti, Gallegati, Greenwald et al.[8] model a credit network characterized by credit relationships. Dosi, Fagiolo, Napoletano et al.[9] model a banking sector and a monetary authority setting interest rates and credit lending conditions in a framework combining Keynesian mechanisms of demand generation, a Schumpeterian innovation-fueled process of growth and Minskian credit dynamics.

There have been models incorporating ACE features into DSGE models. Among those, the complexity framework comprehensively described in Hommes[10], provides a minimal way of generating complex dynamics via heterogeneous agents with varying degrees of rationality. The Brock-Hommes framework has been used by a number of authors to propose a behavioural version of the standard New Keynesian (NK) model with rational expectations (see e.g., Woodford and Walsh[11]). These include Branch and McGough[12], De Grauwe and Kaltwasser[13], Massaro[14], Jang and Sacht[15], and Galí[16]. Branch and McGough[17] provides a recent survey. Dilaver, Calvert Jump and Levine[18] provides a brief review of existing macroeconomic models in literature, their weaknesses, and future perspective. Cherrier, Duarte and Saïdi[19] trace the rise of heterogeneous household models in mainstream macroeconomics from the turn of the 1980s to the early 2000s. They show that different communities across the US and Europe considered heterogeneous agents for various reasons and developed models that differed in their theoretical and empirical strategies.