The Conceptual Flaw in the Microeconomic Foundations of Dynamic Stochastic General Equilibrium Models

First-generation dynamic stochastic general equilibrium (DSGE) models have been criticized for their lack of financial markets but, more perceptively, for their barter properties. This note explains why the second of these criticisms is fundamental. All DSGE models are built on frictionless, perfect barter, Walrasian microeconomic foundations. Introducing money and banks into such models converts them into a ‘friction’ contra the fundamental principle that monetary exchange is more efficient than barter. This insoluble difficulty with the microeconomic foundations of DSGE models arises because theorists ignore the Hahn problem that applies to all monetary models based on Walrasian general equilibrium (GE) microeconomic foundations. The Hahn problem reveals three things. First, a perfect barter GE solution always exists in any ‘monetary’ model erected on Walrasian GE microeconomic foundations. Second, inessential monetary features are easily attached to perfect barter microeconomic foundations but as easily removed, leaving the perfect barter solution intact. Third, attaching such inessential additions leads to logical error; the misuse of language that produces invalid conclusions. A second-generation DSGE model that is intended to increase understanding of financial crises is then examined to show that it suffers from the Hahn problem; it converts banking and financial markets into ‘frictions’, and words and economic concepts take on different meanings. That renders the new DSGE model impossible to interpret or use as a basis for advice on monetary policy.     

Book reviews

Abstract

It is a commonly accepted view that the parity theory of forward exchange based on the law of one price was first formulated by Keynes. In this article we assess the preliminary shapes of the interest parity (IP) relation. After reviewing the early beginnings of the IP relation, we investigate two French economists of the mid-nineteenth century who have hitherto received no adequate attention. We argue that Bonnet and Juglar ought to be considered pioneers in the assessment of IP relation since Goschen's contribution is related to the specificity of ‘long’ exchange rates at a bimetallic time.     

Book reviews

Book reviewed in this article:
Brada, Josef C, Singh, Inderjit, Török, Ádám, Firms Afloat and Firms Adrift: Hungarian Industry and the Economic Transition
Kornai, Jaenos, Overcentralization in Economic Administration - A Critical Analysis Based on Experience in Hungarian Light Industry     

Book reviews

B.G.Dale & J.J.Plunkett (eds) Hemel Hempstead, Philip Allan,1989, 350 pp., £ 18.00

Theories and Technologies of the Knowledge SocietyNiels Ole Finnemann (ed) Centre for Cultural Research, University of Aarhus, Denmark, 1989, 100 pp., DK40

The Internationalisation of Software and Computer Services OECD Paris, OECD, 1989, 180pp., Ff120

Techno-diplomacy. US-Soviet Confrontations in Science and Technology Glenn E. Schweitzer New York and London, Plenum Press, 1989, xiv f 320 pp., $23.00

Strategic Management of Services in the Arab Gulf States: Company and Industry Cases M. Sami Kassem & Ghazi M. Habib Berlin, Walter de Gruyter, 1989, 480 pp.     

Book reviews

Innovation and Industrial Strength in the UK, West Germany, United States and Japan Joan Cox &; Herbert Kriegbaum London, Policy Studies Institute, 1989, 168pp. Industrial Societies After the Stagnation of the 1970s. Taking Stock from an Interdisciplinary Perspective Burkhard Strumpel (ed.) Berlin, de Gruyter, 1989, 313pp.

The Social Basis of the Microelectronics Revolution Alfonso Hernan Molina Edinburgh, Edinburgh University Press, 1989, xxi + 260pp., £25.00 h/b (also avail-able in p/b)

Innovation and Technology Transfer in Japan and Europe: Industry-Academic Relations Glynn 0. Philips (assisted by Michael Hughes) London, Routledge, 1990, 282pp.) £45.00

Banking 1992-A Eurostudy Special Report Ian Gillespie (ed.) I,ondon, Eurostudy Publishing, 1990, 162pp., $£60 ($99)     

Book reviews

The Co-operation Phenomena: Prc)spects for Small Firms and the Small EconomiesDermont O'Doherty (Ed.)London, Irish Science and Technology Ajrency, Graham & Trotman, 1990, 270pp.

Flexible Manufacturing Technologies & International Competitiveness J. Tidd London, Pinter, 1991, ll3pp., £35.00.

Technology Strategy and the Firm: Management and Public Policy Mark Dodgson (Ed.)London, Longman, 1990, 252pp., £25.00 pb.

Computerization in Developing Countries: Model and Reality Per Lind London, Routledge, 1990, 175pp., £35.00 hb.

The Fifth Branch—Science Advisers as Policy Makers Sheila Jasonoff Cambridge, MA, Haroard University Press, 1990, 302pp., £22.50.     

Book reviews

I am indebted to the Department of Economics at the University of Warwick for their hospitality while I was working on this review.