Model Uncertainty in Macroeconomics: On the Implications of Financial Frictions
Quantitative macroeconomic models play an important role in informing policy makers at central banks and other institutions about the consequences of monetary, fiscal and macroeconomic policies. Macroeconomic models, however, have been criticized for failing to predict the Great Recession of 2008/09 or at least failing to provide adequate warning of such a massive contraction.
This criticism has further inspired researchers to work on better integrating imperfections and risks associated with the financial sector in business cycle analysis. The authors review some of the recent developments in structural macroeconomic modelling and then analyze the implications of these models for the design of monetary policy by drawing upon a public model archive (www.macromodelbase.com).
The models suggest that a simple policy rule robust to model uncertainty involves a weaker response to inflation and the output gap in the presence of financial frictions as compared to earlier generations of such models. Leaning-against-the-wind policies in models of this class estimated for the euro area do not lead to substantial gains. The authors argue that the speedy adoption of New Keynesian DSGE models featuring financial frictions in the toolkit of central banks should be acclaimed and central banks would be well advised to increase the diversity of modelling approaches they employ.