TORONTO, Aug. 16, 2011 - Our understanding of the links between the financial sector and the rest of the economy needs to improve, concludes a new report from the C.D. Howe Institute. In When Nightmares Become Real: Modelling Linkages between the Financial Sector and the Real Economy in the Aftermath of the Financial Crisis, authors Philippe Bergevin, Pierre Duguay and Paul Jenkins say that the complexity of these linkages have been neglected in the models typically used to guide monetary policy - the question is how to remedy deficiencies in policymakers’ economic models of the world, so that they can be used with confidence in guiding policy.
Duguay and Jenkins, former Deputy Governor and Senior Deputy Governor at the Bank of Canada, along with C.D. Howe Policy Analyst Bergevin, say that considerable progress is being made in modeling the complexities of the linkages between the financial sector and the real economy - the goods and services sectors. However, the economic models that central bankers use do not cope well with shocks such as those of 2007-08.
While Canada's inflation-targeting framework has proven effective in anchoring expectations and in helping shape the monetary policy response to the crisis, the models widely used by central banks to guide policy proved inadequate during the crisis because they neglected the complex interdependencies within the financial system and between the financial system and the real economy. Such neglect can impose substantial costs to output and employment, if it leads to less than optimal monetary policy choices.
The need to factor in a rich representation of the linkages between the financial sector and the real economy is also important to determining the extent to which monetary policy should be used to counteract the buildup of systemic risk in the financial system.
For the study:
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