Macro Model Agreements vs Disagreements6/6/2012 7:47:00 PM

AGREEMENTS BETWEEN MODELS 1. 2. 3. 4. 5. 6. 7. Inflation Is Always and Everywhere a Monetary Phenomenon The Benefits of Price Stability No Long-Run Tradeoff Between Unemployment and Inflation The Crucial Role of Expectations The Taylor Principle The Time-Inconsistency Problem Central Bank Independence

8. Commitment to a Nominal Anchor 9. Institutions Rule DISAGREEMENTS

There are six basic areas of disagreements: 1) how flexible wages and prices are, 2) how long it takes to get to the long run, 3) the sources of business cycle fluctuations, 4) whether stabilization policy is worth-while, 5) how costly it is to reduce inflation, and 6) how dangerous budget deficits are. Economists generally fall into two camps on these issues, classical and Keynesian. We discuss how views from each of these camps differ for each of these issues.

1. How Much Time It Takes to Get to the Long Run Classical economists believe that it takes only a very short time to get to the long run because wages and prices are flexible Traditional Keynesians view that it takes a long time to get to the long run indeed because of Keyness adage that, in the long run we are all dead New Keynesian economists, who believe in rational expectations and adopt microeconomic foundations, see the economy as moving to the long run far more quickly than traditional Keynesians who adopt the view that expectations may be slow to adjust because they are adaptive 2. Sources of Business Cycle Fluctuations Real business cycle theorists see fluctuations in economic activity as solely a result of shocks to long-run aggregate supply

Keynesian economists see demand shocks as a major source of economic fluctuations New Keynesian economists see the short-run aggregate supply curve as shifting faster than traditional Keynesians because of rational expectations 3. The Dangers of Budget Deficits While the majority of macroeconomists see budget deficits as dangerous, those who believe in Ricardian equivalence are much more sanguine about government budget deficits as they do not improve any further burden on future generations.

Final Class Econ 405

Comparison of Keynesian-Classicalist Macro Models Sustainable Recovery Job Creation

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Describe how both Keynesian-Classicalist macro models in the Mishkin text (and supplemental views provided in the reading by Keynes, Fisher, Minsky and Rasmus) might explain why the recent recession was relatively worse than prior recessions? Describe how each model might explain why the recovery from recession the past three years has been more difficult to achieve? What set of fiscal-monetary (or other) policies would you offer to enable a more rapid, full recovery of the US economy in the years ahead?

Real Business Cycle Theory:

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6/6/2012 7:47:00 PM SOURCES: Mishkin Text Keynes Fisher Minsky Rasmus In Classical economic theory, unemployment is seen as a sign that smooth labor market functioning is being obstructed in some way. The Classical approach assumes that markets behave as described by the idealized supply-and-demand model: the labor market is seen as though it were a single, static market, characterized by perfect competition, spot transactions, and institutions for double-auction bidding. Source: http://www.eoearth.org/article/Theories_of_unemployment As the Classical-Keynesian synthesis took form, many economists came to favor a more Keynesian explanation for cyclical unemployment. Given enough time, they argued, markets might be able to adjust as described in the Classical model. But Keynesian-oriented economists also developed "sticky wage" theories, which hypothesize that wages may stay at a level above equilibrium for some time. Wages may eventually adjust in the way shown in the Classical model, but too slowly to keep the labor market always in equilibrium. Source: http://www.eoearth.org/article/Theories_of_unemployment 1. Describe how both Keynesian-Classicalist macro models in the Mishkin text might explain why the recent recession was relatively worse than prior recessions? 2. Describe how each model might explain why the recovery from recession the past three years has been more difficult to achieve? 3. What set of fiscal-monetary (or other) policies would you offer to enable a more rapid, full recovery of the US economy in the years ahead?

List Recession

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The history of recessions in the United States since the Great Depression show they are a natural, though painful, part of the business cycle. The NBER considers a short recession to have occurred in 1980, followed by a short period of growth and then a deep recession. Unemployment remained relatively elevated in between recessions. The recession began as the Federal Reserve, under Paul Volcker, raised interest rates dramatically to fight the inflation of the 1970s. The early '80s are sometimes referred to as a "double-dip" or "Wshaped" recession. The Iranian Revolution sharply increased the price of oil around the world in 1979, causing the 1979 energy crisis. This was caused by the new regime in power in Iran, which exported oil at inconsistent intervals and at a lower volume, forcing prices up. Tight monetary policy in the United States to control inflation led to another recession. The changes were made largely because of inflation carried over from the previous decade because of the 1973 oil crisis and the 1979 energy crisis. After the lengthy peacetime expansion of the 1980s, inflation began to increase and the Federal Reserve responded by raising interest rates from 1986 to 1989. This weakened but did not stop growth, but some combination of the subsequent 1990 oil price shock, the debt accumulation of the 1980s, and growing consumer pessimism combined with the weakened economy to produce a brief recession The 1990s were the longest period of growth in American history. The collapse of the speculative dot-com bubble, a fall in business outlays and investments, and the September 11th attacks,[46] brought the decade of growth to an end. Despite these major shocks, the recession was brief and shallow.[47] Without the September 11th attacks, the economy might have avoided recession altogether. The subprime mortgage crisis led to the collapse of the United States housing bubble. Falling housing-related assets contributed to a global financial crisis, even as oil and food prices soared. The crisis led to the failure or collapse of many of the United States' largest financial institutions: Bear Stearns, Fannie Mae, Freddie

Mac, Lehman Brothers and AIG, as well as a crisis in the automobile industry. The government responded with an unprecedented $700 billion bank bailout and $787 billion fiscal stimulus package. The National Bureau of Economic Research declared the end of this recession over a year after the end date.[51]

Epic Recession

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1. Describe how both Keynesian-Classicalist macro models in the Mishkin text might explain why the recent recession was relatively worse than prior recessions? Quantitative Characteristics: Depth of economic decline o GDP o Employment o Industrial Production o Exports o Stock Market Duration o Peak to trough Levels or degrees of debt o Public debt o Consumer debt o Business debt (bank & non-bank) Deflation o Asset price deflation

o Product price deflation o Labor market or wage deflation Default o Financial institution Insolvency o Non-bank business bankruptcy o Consumer delinquencies o Public sector (government bonds) Qualitative Characteristics: Financial Fragility o A condition in which banks and non-financial companies are unable to cover their payments that come due on prior debt. o Cash-liquid asset decline, debt level rise, debt quality deterioration o Firms engaged in overaggressive acquisitions and expansions during the boom phase of the business cycle

o Financial Fragilitya growing difficulty in making debt payments as the income for making payments declines, the total debt rises, and the cost of the rising debt grows. Financial Instability o Occurs when financial fragility has reached, and passed, breaking point (fiscal cliff) o Financial institution failures REITs (real estate investment trusts) Capital loss and insolvency Runs on the bank Unavailability of credit Shadow banking system o Mutual Saving Banks o Life Insurance Companies o Brokers and Dealers o Savings and Loans (S&Ls) Consumption fragility o Households encounter growing stress in making payments on debt as the cost of that debt rises as disposable real income stagnates or falls. Shift to speculative investing relative to traditions forms o Short-run, price-driven, capital gain based on a representative bet that the price of the financial instrument will rise. o Vast amounts of capital go into speculation in the price movements of stock, instead of real investment projects becoming divorced from the original real assets in the longer run. o Hyman Minsky writes, the increasing debt accumulation over long asset price-booms periods results in a growing debt load that must be serviced regardless of eventual changes in economic conditions. Hedge financing Speculative Financing Ponzi Finance o (Keynes) Investing drives real economic contractions

investment determines economic crisis (Minsky) Finance determines that

investment

Global synchronization o Propaganda that, since the world is no longer on a gold standard, and if it can prevent trade protectionism, then a synchronized global downturn and depression is avoidable. (Black-Scholes Model)

2. Describe how each model might explain why the recovery from recession the past three years has been more difficult to achieve? 3. What set of fiscal-monetary (or other) policies would you offer to enable a more rapid, full recovery of the US economy in the years ahead?

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