Misunderstanding Money, Banking and Finance in Dynamic Stochastic General Equilibrium (DSGE) Model
The title of Wallace‟s (2004) working paper, Central-Bank Interest-Rate Control in a Cashless, ArrowDebreu Economy is an obvious oxymoron but beautifully captures the state of misunderstanding about the treatment of money, banking and finance in DSGE models. There is no role for money, banking and finance in the ArrowDebreu (AD) „economy‟ so there is nothing for a central bank to do in DSGE models erected on AD GE foundations.
Money, banks and finance are not required in such models because they generate frictionless barter GE solutions. Misapplication of the AD GE concept to DSGE models is the source of all the misunderstanding and confusion that currently exists in macroeconomics because it forces theorists to introduce institutions into GE models where they are not required, changing the meaning of words and long-established economic concepts.
This paper examines the models by Gertler and Kardi (2011) and Gertler and Kiyotaki (2015) to illustrate the misunderstanding of money and banking now common in DSGE models. In particular, the concept of Woodford‟s cashless (moneyless) limit precludes the analysis of monetary policy and the use of barter banks in a moneyless model precludes any understanding of liquidity crises and bank runs.
Barter banks; moneyless, frictionless barter; DSGE models.
JEL CODES: E44; E13; E50; G21.