The integration of the financial system in macroeconometric models for policy simulation

The contribution surveys the role of financial factors in macro-econometric models for policy simulation. The development of models taking into account financial intermediation has been spurred by the apparent failure of mainstream approaches such as dynamic stochastic general equilibrium (DSGE) modelling to predict the GFC of 2007–8 as well as the euro-area sovereign debt crisis and to incorporate the transmission mechanisms through which these affected the real economy. This chapter focuses specifically on a Stock-Flow Consistent (SFC) model developed by economists working at the Italian Treasury; one of its main features is the key role played by sectoral balance sheets, which enables it to capture much more accurately some of the patterns that emerged during the GFC. Possible extensions include modelling inflation, the expectation formation mechanism, asset pricing without arbitrage restrictions and linking trends in financial markets with productivity and demographic developments. The authors argue that this framework represents a useful complement to DSGE models and that the best way forward might be to improve rather than dismiss altogether the latter by adopting an eclectic approach.