Towards a Dynamic Disequilibrium Theory with Randomness

The 2008 Global Financial Crisis, and the myriad other crises confronting economies around the world, exposed the inadequacies of the Dynamic Stochastic General Equilibrium Models. These models not only hadn’t predicted the crisis, its occurrence was completely outside of their framework. The framework assumes there are no macroeconomic inconsistencies—all plans are realized, all budget constraints honored. But after each instance in which that assumption is proved wrong, say in a crisis, the DSGE models assume that kind of event won’t happen again. By contrast, our framework explains why these inconsistencies arise and investigates the consequences, shows how large changes in the aggregate demand could trigger inconsistencies, explains the origins of such changes, and explains why decentralized market forces may be disequilibrating. We identify the crucial departures from the Arrow-Debreu assumptions underlying our results. We analyze the policy implications of this alternative theory, which typically are distinctly different from those of the standard model.