The prevalent macroeconomic models assume the economy is moving along a rational-expectations path in full equilibrium—all transversality conditions are satisfied and, in the absence of nominal wage and price rigidities, all markets clear. Disturbances are typically modeled as technology shocks with known distributions—quite different from the macroeconomic shocks experienced in the last twenty-five years, including September 11th, the global financial crisis, the pandemic, and Russia’s invasion of Ukraine. With climate change, not even the fluctuations in weather can be well described by a stationary stochastic process with known parameters.
However, in the absence of a full set of markets extending infinitely far into the future, outside the representative agent model, there is no plausible mechanism by which such an equilibrium might be attained. Indeed, even within a representative agent model with finitely lived individuals, there are, in general, an infinity of rational expectations trajectories, most of which neither converge nor diverge, confronting the economy with a critical coordination problem. Moreover, because there is no presumption of common knowledge, disparities in beliefs will give rise to bets and surrogates for bets, which in turn give rise to and amplify fluctuations in aggregate demand. The resulting fluctuations may be larger than the ability of sluggishly adjusting wages and prices. Inevitably, there will be moments in which it becomes apparent that there are macroeconomic inconsistencies—previously made plans will not and cannot be fulfilled; these are frequently the moments of crises that are followed by deep economic downturns, partly because the natural adjustment processes may be disequilibrating.
The lecture will attempt to identify many of the key assumptions that have made the standard model less than useful in preventing major economic downturns and responding to crises. Some of the same flawed assumptions are today influencing central bank policies in responding to inflation, policies that are likely to have only a limited effect in curbing inflation, and may in fact exacerbate it, and represent a threat to the performance of the real economy both in the short and medium term.