Modelling reality: The need for both inter-temporal optimization and stickiness in models for policy-making

This paper contributes to the ongoing debate on the usefulness of economic models for policy analysis. It argues that there is a need for models which incorporate both the modern inter-temporal approach to macroeconomics and short-run ad-hoc behaviour. This need cannot be met by the simple models that permeate the macroeconomics literature, but requires large-scale simulation models such as the MSG2 and G-Cubed multi-country models. It is shown that these models give insights into the adjustment process in a number of historical episodes which are not well explained by simple macroeconomic frameworks: Reaganomics in the 1980s; German reunification in the early 1990s; fiscal consolidation in Europe in the mid-1990s; the formation of NAFTA; the Asian Crisis; and the current productivity boom in the USA. The paper also argues that using a well-defined theoretical specification but introducing real-world rigidities can also help to explain the 'six major puzzles in international macroeconomics' highlighted in a recent paper by Obstfeld and Rogoff (2000).