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67-405: As a practical matter, people often use the term "DSGE models" to refer to a particular class of classically quantitative econometric models of business cycles or economic growth called real business cycle (RBC) models. DSGE models were initially proposed by Kydland & Prescott, and Long & Plosser; Charles Plosser described RBC models as a precursor for DSGE modeling. As mentioned in

134-444: A real business cycle (RBC) model to "predict the consequence of a particular policy rule upon the operating characteristics of the economy." The stated, exogenous , stochastic components in their model are "shocks to technology" and "imperfect indicators of productivity." The shocks involve random fluctuations in the productivity level, which shift up or down the trend of economic growth. Examples of such shocks include innovations,

201-700: A spurious relationship where two variables are correlated but causally unrelated. In a study of the use of econometrics in major economics journals, McCloskey concluded that some economists report p -values (following the Fisherian tradition of tests of significance of point null-hypotheses ) and neglect concerns of type II errors ; some economists fail to report estimates of the size of effects (apart from statistical significance ) and to discuss their economic importance. She also argues that some economists also fail to use economic reasoning for model selection , especially for deciding which variables to include in

268-883: A DSGE model, called the Smets–Wouters model, which it uses to analyze the economy of the Eurozone as a whole. The Bank's analysts state that The main difference between " empirical " DSGE models and the "more traditional macroeconometric models, such as the Area-Wide Model", according to the ECB, is that "both the parameters and the shocks to the structural equations are related to deeper structural parameters describing household preferences and technological and institutional constraints." The Smets-Wouters model uses seven Eurozone area macroeconomic series: real GDP ; consumption ; investment ; employment ; real wages ; inflation ; and

335-475: A country rich, not large amounts of money . Output is the result of an economic process that has used inputs to produce a product or service that is available for sale or use somewhere else. Net output , sometimes called netput is a quantity, in the context of production, that is positive if the quantity is output by the production process and negative if it is an input to the production process. The profit-maximizing output condition for producers equates

402-416: A decrease in the unemployment, as hypothesized . If the estimate of β 1 {\displaystyle \beta _{1}} were not significantly different from 0, the test would fail to find evidence that changes in the growth rate and unemployment rate were related. The variance in a prediction of the dependent variable (unemployment) as a function of the independent variable (GDP growth)

469-749: A financial crisis." Oxford University 's John Muellbauer put it this way: "It is as if the information economics revolution, for which George Akerlof, Michael Spence and Joe Stiglitz shared the Nobel Prize in 2001, had not occurred. The combination of assumptions, when coupled with the trivialisation of risk and uncertainty...render money, credit and asset prices largely irrelevant... [The models] typically ignore inconvenient truths." Nobel laureate Paul Krugman asked, "Were there any interesting predictions from DSGE models that were validated by events? If there were, I'm not aware of it." Austrian economists reject DSGE modelling. Critique of DSGE-style macromodeling

536-593: A regression. In some cases, economic variables cannot be experimentally manipulated as treatments randomly assigned to subjects. In such cases, economists rely on observational studies , often using data sets with many strongly associated covariates , resulting in enormous numbers of models with similar explanatory ability but different covariates and regression estimates. Regarding the plurality of models compatible with observational data-sets, Edward Leamer urged that "professionals ... properly withhold belief until an inference can be shown to be adequately insensitive to

603-407: A way in which the consumer links decisions to consume now with decisions to consume later and thus achieves maximum utility in each period. Our marginal Utility from consumption today must equal our marginal utility from consumption in the future, with a weighting parameter that refers to the valuation that we place on the future relative to today. And since the consumer is supposed to always

670-480: Is an application of statistical methods to economic data in order to give empirical content to economic relationships. More precisely, it is "the quantitative analysis of actual economic phenomena based on the concurrent development of theory and observation, related by appropriate methods of inference." An introductory economics textbook describes econometrics as allowing economists "to sift through mountains of data to extract simple relationships." Jan Tinbergen

737-468: Is at the core of Austrian theory, where, as opposed to RBC and New Keynesian models where capital is homogeneous capital is heterogeneous and multi-specific and, therefore, production functions for the multi-specific capital are simply discovered over time. Lawrence H. White concludes that present-day mainstream macroeconomics is dominated by Walrasian DSGE models, with restrictions added to generate Keynesian properties: Hayek had criticized Wicksell for

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804-432: Is built around three interrelated sections including that of demand , supply , and the monetary policy equation. These three sections are formally defined by micro-foundations and make explicit assumptions about the behavior of the main economic agents in the economy, i.e. households , firms, and the government. The interaction of the agents in markets cover every period of the business cycle which ultimately qualifies

871-464: Is estimated to be 0.83 and β 1 {\displaystyle \beta _{1}} is estimated to be -1.77. This means that if GDP growth increased by one percentage point, the unemployment rate would be predicted to drop by 1.77 * 1 points, other things held constant . The model could then be tested for statistical significance as to whether an increase in GDP growth is associated with

938-425: Is given in polynomial least squares . Econometric theory uses statistical theory and mathematical statistics to evaluate and develop econometric methods. Econometricians try to find estimators that have desirable statistical properties including unbiasedness , efficiency , and consistency . An estimator is unbiased if its expected value is the true value of the parameter; it is consistent if it converges to

1005-490: Is needed," according to the authors, "to explain aggregate movements in employment in an equilibrium model ." For the K&;P model, monetary policy is irrelevant for economic fluctuations. The associated policy implications were clear: There is no need for any form of government intervention since, ostensibly, government policies aimed at stabilizing the business cycle are welfare-reducing. Since microfoundations are based on

1072-639: Is often considered the starting point of RBC theory and of DSGE modeling in general and its authors were awarded the 2004 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel . By applying dynamic principles, dynamic stochastic general equilibrium models contrast with the static models studied in applied general equilibrium models and some computable general equilibrium models. DSGE models employed by governments and central banks for policy analysis are relatively simple. Their structure

1139-709: Is one of the two founding fathers of econometrics. The other, Ragnar Frisch , also coined the term in the sense in which it is used today. A basic tool for econometrics is the multiple linear regression model. Econometric theory uses statistical theory and mathematical statistics to evaluate and develop econometric methods. Econometricians try to find estimators that have desirable statistical properties including unbiasedness , efficiency , and consistency . Applied econometrics uses theoretical econometrics and real-world data for assessing economic theories, developing econometric models , analysing economic history , and forecasting . A basic tool for econometrics

1206-443: Is satisfied when unplanned inventory investment equals zero: Output is the result of an economic process that has used inputs to produce a product or service that is available for sale or use somewhere else. Net output, sometimes called netput, is a quantity, in the context of production, that is positive if the quantity is output by the production process and negative if it is an input to the production process. In macroeconomics,

1273-444: Is the multiple linear regression model. In modern econometrics, other statistical tools are frequently used, but linear regression is still the most frequently used starting point for an analysis. Estimating a linear regression on two variables can be visualised as fitting a line through data points representing paired values of the independent and dependent variables. For example, consider Okun's law , which relates GDP growth to

1340-399: Is the same with another in terms of access to credit; not every consumer really considers what they will be doing at the end of their life in any coherent way, so there is no concept of a "permanent lifetime income", which is central to DSGE models; and, therefore, trying to "aggregate" all these differences into one, single "representative agent" is impossible. These assumptions are similar to

1407-429: Is to estimate the parameters, β 0  and  β 1 {\displaystyle \beta _{0}{\mbox{ and }}\beta _{1}} under specific assumptions about the random variable ε {\displaystyle \varepsilon } . For example, if ε {\displaystyle \varepsilon } is uncorrelated with years of education, then

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1474-512: The Cowles Commission Monograph , where he submitted that The Lucas critique is representative of the paradigm shift that occurred in macroeconomic theory in the 1970s towards attempts at establishing micro-foundations . In the 1980s, macro models emerged that attempted to directly respond to Lucas through the use of rational expectations econometrics . In 1982, Finn E. Kydland and Edward C. Prescott created

1541-526: The 2007–2008 financial crisis but argues that the applicability of these models is "improving," and claims that there is growing consensus among macroeconomists that DSGE models need to incorporate both " price stickiness and financial market frictions." Despite his criticism of DSGE modelling, he states that modern models are useful: Still, Kocherlakota observes that in "terms of fiscal policy (especially short-term fiscal policy), modern macro-modeling seems to have had little impact. ... [M]ost, if not all, of

1608-607: The 2007–2008 financial crisis , MIT professor of Economics Robert Solow criticized the DSGE models currently in use: Commenting on the Congressional session, The Economist asked whether agent-based models might better predict financial crises than DSGE models. Former Chief Economist and Senior Vice President of the World Bank Paul Romer has criticized the "mathiness" of DSGE models and dismisses

1675-425: The business cycle , the "stand-in consumer [of the model] values not only consumption but also leisure," meaning that unemployment movements essentially reflect the changes in the number of people who want to work. " Household-production theory ," as well as "cross-sectional evidence" ostensibly support a "non-time-separable utility function that admits greater inter-temporal substitution of leisure, something which

1742-499: The natural logarithm of a person's wage is a linear function of the number of years of education that person has acquired. The parameter β 1 {\displaystyle \beta _{1}} measures the increase in the natural log of the wage attributable to one more year of education. The term ε {\displaystyle \varepsilon } is a random variable representing all other factors that may have direct influence on wage. The econometric goal

1809-490: The neoclassical growth model , under the assumption of flexible prices, to study how real shocks to the economy might cause business cycle fluctuations. The "representative consumer" assumption can either be taken literally or reflect a Gorman aggregation of heterogenous consumers who are facing idiosyncratic income shocks and complete markets in all assets. These models took the position that fluctuations in aggregate economic activity are actually an "efficient response" of

1876-528: The nominal , short-term interest rate . Using Bayesian estimation and validation techniques , the bank's modeling is ostensibly able to compete with "more standard, unrestricted time series models, such as vector autoregression , in out-of-sample forecasting." Bank of Lithuania Deputy Chairman Raimondas Kuodis disputes the very title of DSGE analysis: The models, he claims, are neither dynamic (since they contain no evolution of stocks of financial assets and liabilities), stochastic (because we live in

1943-564: The " general equilibrium " aspect of this model. The preferences (objectives) of the agents in the economy must be specified. For example, households might be assumed to maximize a utility function over consumption and labor effort. Firms might be assumed to maximize profits and to have a production function , specifying the amount of goods produced, depending on the amount of labor, capital and other inputs they employ. Technological constraints on firms' decisions might include costs of adjusting their capital stocks, their employment relations, or

2010-421: The 2003 statement by Lucas , the pioneer of modern DSGE modelling: A basic Post Keynesian presumption, which Modern Monetary Theory proponents share, and which is central to Keynesian analysis, is that the future is unknowable and so, at best, we can make guesses about it that would be based broadly on habit, custom, gut-feeling, etc. In DSGE modeling, the central equation for consumption supposedly provides

2077-505: The Introduction, DSGE models are the predominant framework of macroeconomic analysis. They are multifaceted, and their combination of micro-foundations and optimising economic behaviour of rational agents allows for a comprehensive analysis of macro effects. As indicated by their name, their defining characteristics are as follows: The formulation and analysis of monetary policy has undergone significant evolution in recent decades and

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2144-498: The assumptions made in the so-called Ricardian equivalence , whereby consumers are assumed to be forward looking and to internalize the government's budget constraints when making consumption decisions, and therefore taking decisions on the basis of practically perfect evaluations of available information. Extrinsic unpredictability, post-Keynesians state, has "dramatic consequences" for the standard, macroeconomic, forecasting, DSGE models used by governments and other institutions around

2211-427: The choice of assumptions". Output (economics) In economics , output is the quantity and quality of goods or services produced in a given time period, within a given economic network, whether consumed or used for further production. The economic network may be a firm , industry, or nation. The concept of national output is essential in the field of macroeconomics . It is national output that makes

2278-632: The classic RBC models, and the New-Keynesian DSGE models that build on a structure similar to RBC models, but instead assume that prices are set by monopolistically competitive firms, and cannot be instantaneously and costlessly adjusted. Rotemberg & Woodford introduced this framework in 1997. Introductory and advanced textbook presentations of DSGE modeling are given by Galí (2008) and Woodford (2003). Monetary policy implications are surveyed by Clarida , Galí , and Gertler (1999). The European Central Bank (ECB) has developed

2345-464: The confusion of thinking that establishing a rate of interest consistent with intertemporal equilibrium also implies a constant price level. Hayek posited that intertemporal equilibrium requires not a natural rate but the "neutrality of money," in the sense that money does not "distort" (influence) relative prices. Post-Keynesians reject the notions of macro-modelling typified by DSGE. They consider such attempts as "a chimera of authority," pointing to

2412-493: The design of observational studies in econometrics is similar to the design of studies in other observational disciplines, such as astronomy, epidemiology, sociology and political science. Analysis of data from an observational study is guided by the study protocol, although exploratory data analysis may be useful for generating new hypotheses. Economics often analyses systems of equations and inequalities, such as supply and demand hypothesized to be in equilibrium . Consequently,

2479-410: The development of DSGE models has played a key role in this process. As was aforementioned DSGE models are seen to be an update of RBC (real business cycle) models . Early real business-cycle models postulated an economy populated by a representative consumer who operates in perfectly competitive markets. The only sources of uncertainty in these models are "shocks" in technology . RBC theory builds on

2546-452: The economy to exogenous shocks . The models were criticized on a number of issues: In a 1976 paper, Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. Lucas claimed that the decision rules of Keynesian models, such as the fiscal multiplier , cannot be considered as structural, in

2613-808: The effect of education on wages. The most obvious way to control for birthplace is to include a measure of the effect of birthplace in the equation above. Exclusion of birthplace, together with the assumption that ϵ {\displaystyle \epsilon } is uncorrelated with education produces a misspecified model. Another technique is to include in the equation additional set of measured covariates which are not instrumental variables, yet render β 1 {\displaystyle \beta _{1}} identifiable. An overview of econometric methods used to study this problem were provided by Card (1999). The main journals that publish work in econometrics are: Like other forms of statistical analysis, badly specified econometric models may show

2680-453: The equation can be estimated with ordinary least squares . If the researcher could randomly assign people to different levels of education, the data set thus generated would allow estimation of the effect of changes in years of education on wages. In reality, those experiments cannot be conducted. Instead, the econometrician observes the years of education of and the wages paid to people who differ along many dimensions. Given this kind of data,

2747-470: The equation for consumption, this means that all of us do it individually, if this approach is to reflect the DSGE microfoundational notions of consumption. However, post-Keynesians state that: no consumer is the same with another in terms of random shocks and uncertainty of income (since some consumers will spend every cent of any extra income they receive while others, typically higher-income earners, spend comparatively little of any extra income); no consumer

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2814-454: The estimated coefficient on years of education in the equation above reflects both the effect of education on wages and the effect of other variables on wages, if those other variables were correlated with education. For example, people born in certain places may have higher wages and higher levels of education. Unless the econometrician controls for place of birth in the above equation, the effect of birthplace on wages may be falsely attributed to

2881-433: The evolution of DSGE models as such is predictable the direction of this evolution is not. In effect, Lucas ' notion of the systematic instability of economic models carries over to DSGE models proving that they are not solving one of the key problems they are thought to be overcoming. Federal Reserve Bank of Minneapolis president Narayana Kocherlakota acknowledges that DSGE models were "not very useful" for analyzing

2948-516: The fact that DSGE models evolve (see next section) constitutes a contradiction of the modelling approach in its own right and, ultimately, makes DSGE models subject to the Lucas critique . This contradiction arises because the economic agents in the DSGE models fail to account for the fact that the very models on the basis of which they form expectations evolve due to progress in economic research. While

3015-408: The factors of production. Just as increases in usage or effectiveness of factors of production can cause output to go up, anything that causes labour, capital or their effectiveness to go down will cause a decline in output or at least a decline in its rate of growth. Exchange of output between two countries is a very common occurrence, as there is always trade taking place between different nations of

3082-411: The field of econometrics has developed methods for identification and estimation of simultaneous equations models . These methods are analogous to methods used in other areas of science, such as the field of system identification in systems analysis and control theory . Such methods may allow researchers to estimate models and investigate their empirical consequences, without directly manipulating

3149-620: The highly nonlinear dynamics of economic fluctuations, making training in 'state-of-the-art' macroeconomic modeling "a privately and socially costly waste of time and resources". Narayana Kocherlakota , President of the Federal Reserve Bank of Minneapolis , wrote that N. Gregory Mankiw , regarded as one of the founders of New Keynesian DSGE modeling, has argued that In the 2010 United States Congress hearings on macroeconomic modeling methods, held on 20 July 2010, and aiming to investigate why macroeconomists failed to foresee

3216-497: The inclusion of "imaginary shocks" in DSGE models that ignore "actions that people take." Romer submits a simplified presentation of real business cycle (RBC) modelling, which, as he states, essentially involves two mathematical expressions: The well known formula of the quantity theory of money , and an identity that defines the growth accounting residual A as the difference between growth of output Y and growth of an index X of inputs in production. Romer assigned to residual A

3283-440: The key areas where these models are used, in conjunction with other forecasting methods." University of Minnesota professor of economics V.V. Chari has pointed out that state-of-the-art DSGE models are more sophisticated than their critics suppose: Chari also argued that current DSGE models frequently incorporate frictional unemployment , financial market imperfections , and sticky prices and wages, and therefore imply that

3350-517: The label " phlogiston " while he criticized the lack of consideration given to monetary policy in DSGE analysis. Joseph Stiglitz finds "staggering" shortcomings in the "fantasy world" the models create and argues that "the failure [of macroeconomics] were the wrong microfoundations, which failed to incorporate key aspects of economic behavior". He suggested the models have failed to incorporate "insights from information economics and behavioral economics" and are "ill-suited for predicting or responding to

3417-413: The like. Likewise, income can be sub-divided according to the uses to which it is put – consumption spending, taxes T paid, and the portion of income neither taxed nor spent ( saving S ). Since output identically equals income, the above leads to the following identity: where the triple-bar sign denotes an identity. This identity is distinct from the goods market equilibrium condition, which

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3484-592: The macroeconomy behaves in a suboptimal way which monetary and fiscal policy may be able to improve. Columbia University 's Michael Woodford concedes that policies considered by DSGE models might not be Pareto optimal and they may as well not satisfy some other social welfare criterion. Nonetheless, in replying to Mankiw, Woodford argues that the DSGE models commonly used by central banks today and strongly influencing policy makers like Ben Bernanke , do not provide an analysis so different from traditional Keynesian analysis: Econometrics Econometrics

3551-540: The motivation for the fiscal stimulus was based largely on the long-discarded models of the 1960s and 1970s. In 2010, Rochelle M. Edge, of the Federal Reserve System Board of Directors, contested that the work of Smets & Wouters has "led DSGE models to be taken more seriously by central bankers around the world" so that "DSGE models are now quite prominent tools for macroeconomic analysis at many policy institutions, with forecasting being one of

3618-457: The preferences of decision-makers in the model, DSGE models feature a natural benchmark for evaluating the welfare effects of policy changes. Furthermore, the integration of such microfoundations in DSGE modeling enables the model to accurately adjust to shifts in fundamental behaviour of agents and is thus regarded as an "impressive response" to the Lucas critique. The Kydland / Prescott 1982 paper

3685-430: The prices of their products. Below is an example of the set of assumptions a DSGE is built upon: to which the following frictions are added: The models' general equilibrium nature is presumed to capture the interaction between policy actions and agents' behavior, while the models specify assumptions about the stochastic shocks that give rise to economic fluctuations. Hence, the models are presumed to "trace more clearly

3752-452: The public (including on imported goods) minus imported goods M (the difference being consumption of domestic output), spending G by the government , domestically produced goods X bought by foreigners , planned inventory accumulation I planned inven , unplanned inventory accumulation I unplanned inven resulting from incorrect predictions of consumer and government demand, and fixed investment I f on machinery and

3819-400: The question of why national output fluctuates is a very critical one. And though no consensus has developed, there are some factors which economists agree make output go up and down. If we take growth into consideration, then most economists agree that there are three basic sources for economic growth: an increase in labour usage, an increase in capital usage and an increase in effectiveness of

3886-473: The rate at which society can transform one good into another. When a particular quantity of output is produced, an identical quantity of income is generated because the output belongs to someone. Thus we have the identity that output equals income (where an identity is an equation that is always true regardless of the values of any variables). Output can be sub-divided into components based on whose demand has generated it – total consumption C by members of

3953-416: The relative marginal cost of any two goods to the relative selling price of those goods; i.e. M C 1 M C 2 = P 1 P 2 {\displaystyle {\frac {MC_{1}}{MC_{2}}}={\frac {P_{1}}{P_{2}}}} One may also deduce the ratio of marginal costs as the slope of the production–possibility frontier , which would give

4020-622: The sense that they cannot be invariant with respect to changes in government policy variables, stating: This meant that, because the parameters of the models were not structural, i.e. not indifferent to policy, they would necessarily change whenever policy was changed. The so-called Lucas critique followed similar criticism undertaken earlier by Ragnar Frisch , in his critique of Jan Tinbergen 's 1939 book Statistical Testing of Business-Cycle Theories , where Frisch accused Tinbergen of not having discovered autonomous relations, but "coflux" relations, and by Jacob Marschak , in his 1953 contribution to

4087-416: The shocks' transmission to the economy." This is exemplified in the below explanation of a simplified DSGE model. As such a complete simplified model of the relationship between three key features is defined. This dynamic interaction between the endogenous variables of output, inflation, and the nominal interest rate, is fundamental in DSGE modelling. Two schools of analysis form the bulk of DSGE modeling:

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4154-441: The system. In the absence of evidence from controlled experiments, econometricians often seek illuminating natural experiments or apply quasi-experimental methods to draw credible causal inference. The methods include regression discontinuity design , instrumental variables , and difference-in-differences . A simple example of a relationship in econometrics from the field of labour economics is: This example assumes that

4221-1261: The true value as the sample size gets larger, and it is efficient if the estimator has lower standard error than other unbiased estimators for a given sample size. Ordinary least squares (OLS) is often used for estimation since it provides the BLUE or "best linear unbiased estimator" (where "best" means most efficient, unbiased estimator) given the Gauss-Markov assumptions. When these assumptions are violated or other statistical properties are desired, other estimation techniques such as maximum likelihood estimation , generalized method of moments , or generalized least squares are used. Estimators that incorporate prior beliefs are advocated by those who favour Bayesian statistics over traditional, classical or "frequentist" approaches . Applied econometrics uses theoretical econometrics and real-world data for assessing economic theories, developing econometric models , analysing economic history , and forecasting . Econometrics uses standard statistical models to study economic questions, but most often these are based on observational data, rather than data from controlled experiments . In this,

4288-835: The unemployment rate. This relationship is represented in a linear regression where the change in unemployment rate ( Δ   Unemployment {\displaystyle \Delta \ {\text{Unemployment}}} ) is a function of an intercept ( β 0 {\displaystyle \beta _{0}} ), a given value of GDP growth multiplied by a slope coefficient β 1 {\displaystyle \beta _{1}} and an error term, ε {\displaystyle \varepsilon } : The unknown parameters β 0 {\displaystyle \beta _{0}} and β 1 {\displaystyle \beta _{1}} can be estimated. Here β 0 {\displaystyle \beta _{0}}

4355-401: The weather, sudden and significant price increases in imported energy sources, stricter environmental regulations, etc. The shocks directly change the effectiveness of capital and labour, which, in turn, affects the decisions of workers and firms, who then alter what they buy and produce. This eventually affects output . The authors stated that, since fluctuations in employment are central to

4422-567: The world of Knightian uncertainty and, since future outcomes or possible choices are unknown, then risk analysis or expected utility theory are not very helpful), general (they lack a full accounting framework, a stock-flow consistent framework, which would significantly reduce the number of degrees of freedom in the economy), or even about equilibrium (since markets clear only in a few quarters). Willem Buiter , Citigroup Chief Economist, has argued that DSGE models rely excessively on an assumption of complete markets , and are unable to describe

4489-622: The world. The mathematical basis of every DSGE model fails when distributions shift, since general-equilibrium theories rely heavily on ceteris paribus assumptions. They point to the Bank of England 's explicit admission that none of the models they used and evaluated coped well during the 2007–2008 financial crisis , which, for the Bank, "underscores the role that large structural breaks can have in contributing to forecast failure, even if they turn out to be temporary." Christian Mueller points out that

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