Models and forecasts are important inputs into any decision-making process …[The] model used in the monetary policy process needs to incorporate the views of the MPC about the way the economy functions, ie to be theoretically coherent, and also be able to replicate historical data on the UK economy, ie to be empirically coherent. It is hard to achieve both of these simultaneously and some trade-off needs to be made when selecting the model.
Apparently it’s not possible for economic models to simultaneously match the data and reflect the way economists view the world. If that were true then it would indicate that economic theory is wrong. Perhaps not categorically wrong, but certainly a long way from reflecting the way the world actually works. It would mean that the modelling simplifications were the wrong ones and discarded important information and mechanisms.
What I think Pagan is trying to get at is that there are two classes of economic models at the moment. The first seeks to document and understand empirical regularities. That includes most econometrics, along with the new agent-based models. These people accuse the more theoretical types of ignoring reality, but they’re also the people who came up with the Phillips curve.
The second is more concerned with understanding how shocks affect an economic system. They build DSGE models and obsess over structural parameters. Rather than worrying about precisely replicating historical series, they concern themselves with estimating how a policy change might affect the economy. These people wave the Lucas critique at empiricists and feel more comfortable hanging out with intertemporally optimising representative agents.
I think Pagan is saying that no model is yet of both worlds but the goal, surely, is to bring these two together. Both are useful tools but the separation is illustrative of our discipline’s present shortcomings.
HT: mainly macro