Formal Approaches

Abstract

Abstract This chapter discusses advances in formal economic theory by examining how different positions among economists arise from their different assumptions and models. The discussion focuses on ways in which real world economies differ from the ‘competitive equilibrium’ model that has become the benchmark model. The current benchmark competitive equilibrium framework includes new classical, representative agent, and real business cycle models which assume that all markets (including the labor market) have clear, perfect information, complete markets (including perfect capital and insurance markets), perfect wage and price flexibility, perfect competition, perfect rationality, and no externalities. If these models accurately portrayed reality, the economy would be efficient and there would be no need for government intervention. The assumptions of these models, however, are unrealistic and it is difficult to reconcile the required macro-formulations with what is known about microeconomic behavior (without resorting to ad hoc assumptions about the nature of the stochastic shocks to preferences and technology). The inadequacies of these models are even greater for developing countries where information imperfections are more pervasive and more markets are missing or incomplete (e.g., insurance markets). Accordingly, economic research since the 1990s has focused on identifying the most important limitations of the standard competitive model, particularly those limitations that help to explain the nature of economic volatility.