Modelling the UK Banking Sector

Ray Barrell, Simon Kirby and E Davis ()

National Institute Economic Review, 2010, vol. 214, F67-F72

Abstract: The financial crisis that emerged during 2007 and overwhelmed the financial system in late 2008 also brought to the fore some of the obvious failings of the style of modelling that had been fashionable in central banks in the previous decade. The shift to Dynamic Stochastic General Equilibrium models (DSGE) of whatever sort left no real scope for money and financial markets to have an impact on the real economy. This was in part because equilibrium models based on theory are unlikely to be designed to cope with a period of disequilibrium, which is when the financial system becomes important in macroeconomics. DSGE models come in various guises, and it was common to operate with a three-equation model with demand, supply and the interest rate as the equations. It is hard to see how the financial sector could fit into this, or what use it would be even if it were included. Larger DSGE models that respect the national income identity are easier to augment with a financial sector; but even that developed by the US Federal Reserve (see Edge, Kiley and Laforte, 2010) tends to return to equilibrium rather more rapidly than seems reasonable.

Date: 2010
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