A Scientific Macroeconomic Model Derived from Fundamental Equation of Economics

Abstract

The poor performance of macroeconomic models during the great recession of 2008 has forced many economists to re-examine macroeconomic theories, and search for creditable alternatives to the popular dynamic stochastic general equilibrium (DSGE) models. This paper derives a new macroeconomic model from recently published Fundamental Equation of Economics (FEOE) and applies the new model to answer a general question what causes economic crises. The macro model known as the indeterministic balance sheet plus (IBS+) model proposed in this paper for the first time turns out to be a special breed of accounting models. Different accounting models are more or less same in the way of handling empirical accounting data and flow of funds, and different in the way of forecasting the future. The IBS+ macroeconomic model takes the indeterministic view of the future balance sheets with the emphasis on probabilistic causalities, tail risks, economic reality described by balance sheet accounting, truthfully capturing the sectorial flow of funds and dynamics of economics, universally applicability, and a rock solid scientific theoretical foundation. The IBS+ model is very different from the popular dynamic stochastic general equilibrium (DSGE) models and agent-based computational economic (ACE) models. Through a side by side comparison, we prove that IBS+ model is superior to DSGE or ACE models in many ways. This paper concludes that DSGE models are probably intellectual dead ends, and economists should stop investing heavily with DSGE models and instead should replace DSGE models with IBS+ models. Economic crises have plagued humanity since the dawn of capitalism. Despite intense studies over last several hundred years, the questions about causes, forecasting, and prevention of economic crises remains unsolved. This paper proposes a classification of causes of economic crises using IBS+ models to analyze balance sheets of key economic sectors. Applying this classification to examine recent economic crises, we conclude that most economic crises are caused by mismanagement of balance sheets by key economic players. This paper suggests that economic crises are largely caused by inevitable misbehavior of humanity and not caused by any fundamental flaw of capitalism. Just like improving the individual health and personal hygiene is the key to prevent epidemic diseases in societies, the key to prevent future economic crises is to promoting financial disciplines and strengthening risk management of key players in economics. Because some economic crises can be caused by natural and man-made factors beyond the scope of economics like earthquakes and wars, the frequency of economic crises can be minimized by proper risk management practices but economic crises can never be completely eliminated. Historically, treating mismanagement of balance sheets as main causes of economic crises is a generalization of Austrian business cycle theory, Fisher’s debt deflation theory, and Minsky’s financial instability hypothesis.