Is dynamic general equilibrium a theory of everything?

Should we interpret the contributions of Edward C. Prescott and his collaborators, especially Finn Kydland and Rajnish Mehra, to dynamic general equilibrium as just a mathematical restatement of pre-Keynesian business cycle theory in the language of Arrow and Debreu? This essay advances the contrary view that Prescott has been laying the foundations for a theory of everything in macroeconomics that will stretch well beyond the frictionless environments treated in its early version. A theory of everything is an attempt to explain key empirical observations in nearly every subfield of macroeconomics from a simple, logically coherent conceptual platform with a minimum of institutional detail. After reviewing the current state of Prescott’s agenda, we examine several examples of dynamic equilibrium in economies with constant returns to scale, complete markets, idiosyncratic productivity shocks, and limited capital mobility. These examples suggest that the Solow residual controls the entire path of aggregate output if redefined more broadly to include financial, distributional and institutional variables; that the discount factor used in pricing streams of income will shift autonomously over time in response to endogenous changes in the set of unconstrained asset traders; and that a dynamic general equilibrium model with substantive frictions in Prepared for the Special Issue of Economic Theory honoring Edward Prescott. We are indebted to Gaetano Antinolfi, Athanasios Bolmatis, Jim Bullard and Bryan Ellickson for many discussions on these issues, to Lee Ohanian for bibliographic suggestions, to Robert Solow and two anonymous referees for comments. Some of the material was presented in a lecture series at the Arne Ryde Foundation, University of Lund, and at Brown University. C. Azariadis Washington University-St. Louis, 63130-4899 St. Louis, MO, USA E-mail: [email protected] L. Kaas (B) University of Konstanz, Box D145, 78457 Konstanz, Germany E-mail: [email protected] 14 C. Azariadis and L. Kaas financial markets goes some distance towards a joint account of well-known empirical anomalies in growth, business cycles, and asset returns.