In this very good recent interview with the always extremely insightful David Laidler on Russ Robert’s Econtalk David rightly highlights the problem that money disappeared from macroeconomics during the 1990s with the development of DSGE models.
I share David’s worry that many macroeconomists – particular central bank economists – use models where there is no money. However, over the last couple of years some economists have tried to bring money into DSGE models. This research deserves a lot more attention.
I have complied a small sample of papers on money in DSGE models:
- Josh Hendrickson
The baseline New Keynesian model consists of a dynamic IS equation, a Phillips curve, and an interest rate rule that describes monetary policy. In recent years, this framework has become standard for monetary policy and monetary business cycle analysis. One charac- teristic of this model, and extensions thereof, is that the path of the short term interest rate fully captures the monetary transmission mechanism. This proposition is contrary to both theory and evidence presented by monetarists and advocates of the credit channel. As a result of these differences, this paper presents a model that includes agency costs, a richer specification of money demand, and nests the baseline New Keynesian model as a special case to evaluate the dynamics implied by each assumption. The results show that the New Keynesian model does a poor job of replicating empirical properties observed in the data. On the other hand, the model employed in this paper that includes elements from both the credit channel and monetarist literature is able to perform quite well. These results suggest that the representation of the monetary transmission process in the New Keynesian model is incomplete.
- Peter Ireland
A small, structural model of the monetary business cycle implies that real money balances enter into a correctly-specified, forward-looking IS curve if and only if they enter into a correctly-specified, forward-looking Phillips curve. The model also implies that empirical measures of real balances must be adjusted for shifts in money demand to accurately isolate and quantify the dynamic effects of money on output and inflation. Maximum likelihood estimates of the model’s parameters take both these considerations into account, but still suggest that money plays a minimal role in the monetary business cycle.
The role of money and monetary policy in crisis periods: the Euro area case
- Jonathan Benchimol and Andre Fourcans
In this paper, we test two models of the Eurozone, with a special emphasis on the role of money and monetary policy during crises. The role of separability between money and consumption is investigated further and we analyse the Euro area economy during three different crises: 1992, 2001 and 2007. We find that money has a rather significant role to play in explaining output variations during crises whereas, at the same time, the role of monetary policy on output decreases significantly. Moreover, we find that a model with non-separability between consumption and money has better forecasting performance than a baseline separable model over crisis periods.
- Jonathan Benchimol
We propose a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model where a risk aversion shock enters a separable utility function. We analyze five periods, each one lasting twenty years, to follow over time the dynamics of several parameters (such as the risk aversion parameter), the Taylor rule coefficients and the role of this risk aversion shock on output and real money balances in the Eurozone. Our analysis suggests that risk aversion was a more important component of output and real money balance dynamics between 2006 and 2011 than it had been between 1971 and 2006, at least in the short run.
This is a of course a very incomplete list of papers, but overall there are still very few papers on money in DSGE models. I hope I with this post can inspire others to look into this interesting topic and hopefully one day even central bankers will come to the conclusion that we need to bring money back into the game.