Economic Modeling in the Post Great Recession Era Incomplete Data, Imperfect Markets

Economic Modeling in the Post Great Recession Era presents a more realistic approach to modeling, using direct statistical applications to address the characteristics and trends central to current market behaviors. This book's unique focus on the reality of today's markets makes it an invaluable resource for students and practitioners seeking a comprehensive guide to more accurate forecasting. While most books treat the economy as if it were in a vacuum, building models around idealized or perception-biased behaviors, this book deals with the economy as it currently stands—in a state of recovery, limited by financial constraints, imperfect information, and lags and disparities in price movements. The authors identify how these characteristics impact various markets' behaviors, and quantify those behaviors using SAS as the primary statistical tool.

Today's economy bears a number of unique attributes that usual modeling methods fail to consider. This book describes how to approach modeling based on real-world, observable data in order to make better-informed decisions in today's markets.

• Discover the three economic characteristics with the greatest impact on various markets
• Create economic models that mirror the current post-recession reality
• Adopt statistical methods that identify and adapt to structural breaks and lags
• Factor real-world imperfections into modeling for more accurate forecasting

The past few years have shown a clear demarcation between policymakers' forecasts and actual outcomes. As the dust settles on the Great Recession, after-effects linger—and impact our current recovery in ways that diverge from past experience and theoretical expectations. Economic Modeling in the Post Great Recession Era provides comprehensive guidance grounded in reality for today's economic decision-makers.

JOHN E. SILVIA is a managing director and the chief economist for Wells Fargo. Previously he worked on Capitol Hill as senior economist for the U.S. Senate Joint Economic Committee and chief economist for the U.S. Senate Banking, Housing, and Urban Affairs Committee.

AZHAR IQBAL is director and econometrician at Wells Fargo Securities.

SARAH WATT HOUSE is vice president of Wells Fargo Securities.

Preface/Justification xiii

Acknowledgments xxi

Chapter 1 Setting the Context 1

The Problem with Uncritical Assumptions in a Less-Than-Perfect Economy 2

The Problem with Models in an Imperfect Economy 3

Four Characteristics of a Less-Than-Perfect Economy 4

Economic Policy Inconsistencies—The Parable of Strange Bedfellows 13

Chapter 2 Dynamic Adjustment in an Economy: Frictions Matter 15

Introduction 16

Quantifying Frictions: Is the Long-Run Average a Useful Guide for the Future? 32

Modeling Dynamic Adjustment due to Economic Frictions: Decision Making in an Evolving World 49

Dynamic Economic Adjustment: An Evolution unto Itself 67

Appendix 68

A Case for the Multiple Markets: 1983–2008 68

The Labor Market: 1983–2008 70

Chapter 3 Information: Past Imperfect, Present Incomplete, Future Uncertain 73

Story Behind the Numbers 76

Conclusion 103

Chapter 4 Price Adjustment and Search for Equilibrium 105

What Barriers Are There to Perfectly Flexible Prices? 107

Implications 112

Finding Dynamic Adjustment in the Data 116

Conclusion 121

Chapter 5 Business Investment: This Time Is Different 123

Drivers of Business Spending 125

Putting It All Together: Explaining Slow Recovery in Capital Investment 134

Chapter 6 Corporate Profits: Reward, Incentive, and That Standard of Living 135

Introduction: Profits as Essential Partner 136

The Role of Profits in the Economic Cycle: Five Drivers 137

The Role of Profits: Incentives and Rewards 140

Concluding Remarks: Modeling Profits 167

Chapter 7 Labor Market Evolution: Implications for Private-Sector and Public-Policy Decision Makers 169

Part I: Labor Market Imperfections 171

Part II: Heterogeneity in the Labor Market 182

Part III: How Do Secular Labor Market Trends Impact Economic Policy? 196

Chapter 8 Inflation: When What You Get Isn’t What You Expect 205

Introduction 206

What Is Inflation? 207

Why Does Inflation Matter? 208

What Determines Inflation? 212

Inflation after the Great Recession 219

Application: Predicting if Central Banks Can Achieve Price Stability 230

Chapter 9 Interest Rates and Credit: Capital Markets in the Post–Great Recession World 235

Imperfect Guidance in an Uncertain World 236

A Look at Actual History over the Long Run 247

Credit and Administered Rates 250

Imperfect Information and Credit 255

Conclusion: Shift from Historical Benchmarks 280

Chapter 10 Three-Dimensional Checkers: Open Economy, Capital Flows, and Exchange Rates 281

Newton’s Third Law 282

Introducing a New Price to the Analysis: The Role of Exchange Rates 289

Three-Dimensional Checkers on an International Playing Field 295

A Perfect Model in an Imperfect World 298

Concluding Remarks: Future Looks Different 330

Chapter 11 Assessing Economic Policy in an Imperfect Economy 331

Generalized Policy Model 333

Rules and Reputation: Beyond Economic Benchmarks 338

Confronting Our Three Market Imperfections 340

Economic Policy in the Context of an Imperfect Economy 359

About the Authors 361

Index 363

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