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Changing Macro-Economics post-Financial Crisis: Integration of Finance Theory

Explore the impact of the Financial Crisis on Macro-Economics, from Keynesian analysis to DSGE models and the role of finance theory. Discuss key concepts such as aggregate demand and supply, national income data, Phillips curve, fiscal deficits, and more.

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Changing Macro-Economics post-Financial Crisis: Integration of Finance Theory

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  1. How will the Financial Crisis change Macro-Economics? By C.A.E. Goodhart Financial Markets Group, London School of Economics

  2. History of Thought • Keynesian Analysis • 1) Keynes G.T. (1936) • • Aggregate (effective) demand and aggregate supply • • Supply side, reverse L shape • • History, plus depressing effect of declining prices (Pigou, or real balance effect). • • Codified as IS/LM • 2) National Income data, 1939-45 • 3) Philips curve, (1958), and output gap • 4) I + X + G = S + M + T (Deficits = Surpluses) • plus computers gives us National Income models in 1960s • 5) Fiscal multiplier clear vs uncertain interest elasticity

  3. B. Keynes vs Monetarism and Lucas • 6) Monetarism vs Keynes in 1960s • • Stability of demand for money function vs stability of Keynesian models • 7) Vertical Phillips curve and importance of expectations • 8) Lucasian critique of N.I. models, no micro-foundation, need for rational expectations • • Agents optimise over rationally expected future • 9) Constraints, Credit, Habits, excessive response of C to I.

  4. C. DSGE • 10) How to deal with diversity; how to make optimising agent model tractable? Answer representative agent, plus transversality condition. • 11) Transversality condition rules out:- • (a) Default • (b) Credit risk premia • (c) Banks • (d) Money! • Yet such DSGE models used by Central Banks • DSGE models are RBC models, where shocks occur only to productivity and preferences, e.g. time preference, plus price/wage stickiness (Calvo pricing), so monetary policy (Taylor reaction function) affects real variables. Woodford Interest and Prices (2003) • Interest rate effects clear vs uncertain fiscal multiplier • (14) Complete disconnect between macro-economics (no default) and Finance, where PoD determines asset pricing

  5. 2. Where are we now after Crisis? • Can no longer use representative agent plus transversality. A continuum of agents with different risk aversion, so variations over time in default rates. Models beginning to adopt this. (Woodford, Gertler) • Inclusion of risk premia into model. (Curdia and Woodford) • Measuring and modelling systemic risk (Brunnermeier, CoVar; Acharya, Systemic Expected Shortfall) • Monetary Theory (R. Wright, Modern Monetarism, vs Credit Theory) • Gary Gorton and the run on the Repo • 6) Macro-economics will reunite with Finance theory.

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