Modelling Reality: The Need for Both Intertemporal Optimization and Stickiness in Models for Policymaking

This paper contributes to the ongoing debate on the usefulness of economic models for policy analysis. It argues that there is a need for models which incorporate both the modern inter-temporal approach to macroeconomics and short-run ad-hoc behaviour. This need cannot be met by the simple models that permeate the macroeconomics literature, but requires large-scale simulation models such as the MSG2 and G-Cubed multi-country models. It is shown that these models give insights into the adjustment process in a number of historical episodes which are not well explained by simple macroeconomic frameworks: Reaganomics in the 1980s; German reunification in the early 1990s; fiscal consolidation in Europe in the mid-1990s; the formation of NAFTA; the Asian Crisis; and the current productivity boom in the USA. The paper also argues that using a well-defined theoretical specification but introducing real-world rigidities can also help to explain the 'six major puzzles in international macroeconomics' highlighted in a recent paper by Obstfeld and Rogoff (2000).