Why Are The Models Wrong?


It's easy to say our economic models are wrong. It is even easier to say the other guy's economic models are wrong. Nick Rowe is asking the more important question, "why are our models wrong?" We only learn through that question.

Nick writes:

The most important thing I have learned from the data over the last few years is that inflation targeting does not work as well as I thought it would. The most important thing I need to figure out is why inflation targeting doesn't work as well as I thought it would. Inflation targeting does not separate real shocks from nominal shocks as well as I thought it would. But I don't really know why inflation targeting failed to separate real from nominal shocks as well as I thought it would.

Economists have not fully disentangled the differences between nominal shocks, generally blamed on bad monetary policy, and real shocks, generally blamed on technology.

Real shocks are unlikely to stop. However, for a while, economists hoped that real shocks would not turn into nominal shocks by wise inflation targeting. Now wise NGDP or NGDPL targeting will prevent nominal shocks from becoming real.

My own impression is that the idea of separating the nominal from the real is doomed from the start. Money is too important in economic planning to be passive in an economy. Most economists would agree with me on this, although Ed Prescott remains strong. Money is also too complex to be managed by the Fed. Most economists would not agree with me on this.

However, until economists understand why our models and understanding of money are wrong, we are navigating blindly (or at least in the fog) and the Fed seems doomed to turn nominal into real and real into nominal for the foreseeable future.