Towards a Dynamic Disequilibrium Theory with Randomness

Abstract

Most macroeconomic crises, such as the 2008 Global Financial Crisis, are associated with endogenous large changes in beliefs and understandings about the workings of the economy. Such downturns and crises are not consistent with the standard paradigm of a well-functioning competitive economy, and macroeconomic equilibrium models based on that paradigm have failed to predict the possibility of those downturns, to explain them, or even to design appropriate policy responses. The framework assumes there are no macroeconomic inconsistencies-all plans are realized, all budget constraints honored.In this paper, we present a dynamic disequilibrium theory with randomness that is based on the premise that a better way to understand deep downturns is to think of the economy experiencing a constant evolution, marked by uncertainty, in which there is continual learning about the economic system. Our framework explains why macroeconomic inconsistencies may arise and investigates their consequences. We explain why decentralized market forces may be disequilibrating. We identify the crucial departures from the Arrow-Debreu assumptions and those underlying DSGE models, emphasizing the limitations in the assumption of equilibrium and the absence of a coherent theory of how it is attained, the incompleteness of markets and the nonstationarity of the stochastic processes describing the economy. We analyze the policy implications of this alternative theory, which typically differ markedly from those of the standard model: In particular, the consequences for the effectiveness of different monetary and fiscal policies, and the eventual need of debt restructuring policies to restore macroeconomic consistency.

The pandemic economic crisis, precautionary behavior, and mobility constraints: an application of the dynamic disequilibrium model with randomness†

“…Besides, and more importantly, decentralized adjustment processes with flexible wages and prices may not converge smoothly to the full employment equilibrium: the short run response may be disequilibrating. (Guzman and Stiglitz (2020)).…”

“…While there might exist a full employment equilibrium if all wages and prices were fully flexible at all dates (and presumably states of nature), 25 this is another example of the theory of the second best: allowing some to be flexible (here wages this period) may make matters worse. Besides, and more importantly, decentralized adjustment processes with flexible wages and prices may not converge smoothly to the full employment equilibrium: the short run response may be disequilibrating ( Guzman and Stiglitz, 2020 ).…”

The pandemic economic crisis, precautionary behavior, and mobility constraints: an application of the dynamic disequilibrium model with randomness

“…Moreover, even when there is coverage, when there are large macroeconomic disturbances (i.e., events which simultaneously affect large numbers of households and firms), private insurance firms often don’t have the financial wherewithal to deliver the benefits promised. This is an example of the macroeconomic inconsistencies emphasized by Guzman and Stiglitz (2020) : events like crises and pandemics entail promises not being fulfilled. Rationally, individuals (except those living in the world of DSGE models) know this, but they do not and cannot know what will happen when these contracts are broken.…”

“…The possibility, or even likelihood, that wage flexibility may have adverse effects has been noted in Delli Gatti et al (2012a , b ). Guzman and Stiglitz (2020) provide a more comprehensive taxonomy of the reasons that that may be the case. See also Dosi et al (2017) .…”

“…This article is based on joint work with Martin Guzman, and represents an application of ideas developed in Guzman and Stiglitz (2020) . The analysis of macroeconomics with limitations on intersectoral mobility is based on joint work with Bruce Greenwald, Domenico Delli Gatti, Mauro Gallegati, and Alberto Russo.…”