Money, Banks and Finance in Economic Thought

Impulses and Propagation Mechanisms in Equilibrium Business Cycles Theories: From interwar debates to DSGE “consensus”

Dal Pont Legrand Muriel, Universite Cote d'Azur CNRS GREDEG
Harald HAGEMANN, University of Hohenheim, Stuttgart

It is tempting to understand the DSGE (Dynamic Stochastic General Equilibrium) approach as a refinement of earlier contributions, namely Slutsky (1927) and Frisch (1933), and to a lesser extent Hayek, Hicks, and Lutz. By analyzing the debates in these periods, we try to show that the modern tools from which our theories benefit, far from being neutral, have deeply changed the nature of business cycles theories. We identify the reduced role of propagation mechanisms in DSGE models and their consequences for current debates. The overemphasis on the capacity of models to mimic cyclical fluctuations on the one side, and the clear incapacity of these models to explain (even to mimic) large scale crises on the other, are distinct but convergent elements which reveal a deep change in the relationship between the empirical findings (data, stylized facts) and the theory. These elements are deserving more attention from historians of economic thought.

Area:

Keywords: equilibrium business cycles theories, dynamics, impulse, shocks, propagation mechanism(s), empirical validation, calibration, crisis.