August 16, 2011 – Our understanding of the links between the financial sector and the rest of the economy needs to improve, concludes a report from the C.D. Howe Institute. In When Nightmares Become Real: Modelling Linkages between the Financial Sector and the Real Economy in the Aftermath of the Financial Crisis, authors Philippe Bergevin, Pierre Duguay and Paul Jenkins say that the complexity of these linkages have been neglected in the models typically used to guide monetary policy – the question is how to remedy deficiencies in policymakers’ economic models of the world, so that they can be used with confidence in guiding policy.
Pierre Duguay and Paul Jenkins, former Deputy Governor and Senior Deputy Governor at the Bank of Canada, along with C.D. Howe Policy Analyst Philippe Bergevin, say that considerable progress is being made in modeling the complexities of the linkages between the financial sector and the real economy (the goods and services sectors). However, the economic models that central bankers use to do so remain stylized, and do not cope well with shocks such as those of 2007-08.
Duguay, Jenkins and Bergevin acknowledge that models are and will always be simplified representations of the economy, and that no one model can answer all questions. The art, they say, is to determine the questions that need to be asked and to develop tools that will yield the appropriate insight to inform policy decisions. Policymakers need a range of models that complement each other, and to use them circumspectly and with full understanding of their limitations.
While Canada’s inflation-targeting framework has proven effective in anchoring expectations and in helping shape the monetary policy response to the crisis, the models widely used by central banks to guide policy proved inadequate during the crisis because they neglected the complex interdependencies within the financial system and between the financial system and the real economy. Such neglect can impose substantial costs to output and employment, by eliciting a suboptimal response from monetary policy authorities.
The need to factor in a rich representation of the linkages between the financial sector and the real economy is also critically important to determining the extent to which monetary policy can, or should, be used to counteract the buildup of systemic risk in the financial system, the key issue from a policy framework perspective.
Click here for the full report.
For more information contact:
Paul Jenkins, Former Senior Deputy Governor;
Pierre Duguay, Former Deputy Governor;
Philippe Bergevin, Policy Analyst,
C.D. Howe Institute,
416-865-1904, email: cdhowe@cdhowe.org