DSGE models and Financial instability
Credit cycles, can only exist if there is a systematic tendency towards over-borrowing (more borrowing than justified by the available resources), as explained below. They are impossible in models where money is a value unit for transactions of current output, and which therefore must exist strictly in proportion to resources and output. All attempts to integrate finance into a general equilibrium (GE) model world therefore picture it as a mere conduit of existing money from savers to investors, in line with a ‘loanable funds’ theory of banking . Mainstream (general) equilibrium macroeconomics so espouses a ‘reflective finance’ view, where the credit system is seen as reflecting economic ‘fundamentals’ in the real sector, such as productivity and resources. Finance itself cannot be the cause of economic volatility; at most, imperfections in financial markets may be, just as wage rigidity in labour markets can be (Kyotaki and Moore, 1997). This explains why there is little theorizing on credit cycles in mainstream economics. Bernanke (1983:258) noted that “only the older writers seemed to take the disruptive impact of financial breakdown for granted”.
As Arestis and Mihailu (2010) show in a recent overview of monetary theory, this is still the case despite innovations in secondary issue such as inclusion of transaction costs, heterogeneous agents, risk, information imperfections, and sticky prices. This characterizes the earliest money-less Walrasian models up to the currently dominant DSGE models, of which Tovar (2008) notes that “the main weakness in current DSGE models, is the absence of an appropriate way of modelling financial markets” (p.5). In consequence, in DSGE models “aggregate financial wealth does not matter for the behaviour of agents or for the dynamics of the economy’ (p.7).