I post the image underneath, in the hope that someone will make some comments. I'm not arguing that it is the best or even good description of what has happened, but it is the best I could come up with in a short period of time.
"AD" refers to the Aggregate Demand, "SRAS" refers to Short Run Aggregate Supply, and "LRAS" refers to Long Run Aggregate Supply. This should be thought of in the context of the Mundell-Fleming model, of an (large) open economy. AD corresponds to the equilibrium between the IS curve(representing the goods market Y=C+I+G+X-M, which one may choose to develop into: ) and LM (representing the money or financial market approximated by the function: M/P = L(Y,i) ).
LRAS refers to the long run equilibrium in the labour market, where Y=Y*, meaning when output is at its equilibrium level, and unemployment is at its natural rate (u=u*), given the NAIRU (Non Accelerating interest rate of unemployment also known as the expectations augmented Phillips curve, given by: π = π* -φ(u*-u)+ s)). The SRAS is then given by: Π= (Π^f) + φ (y-y*) +s'
My biggest problem is with the implications of exchange rate regimes particularly because I haven't quite yet gone through the full model for floating exchange rates.All of these formulas are taken from "Introducing Advanced Macroeconomics", written by Sorensen and Jacobsen. They give a much better explanation of this type of analysis than I do. Nonetheless, as the tittle proposes this is the first draft. It is more intuitive than anything else. Prettier versions in upcoming posts might prove more fitting, as I'll have finished teaching myself this type of analysis...
Anyway, please leave some comments. :)
Hi, Filipe! Just two small questions after a brief read (still at work...):
ReplyDelete- Point C corresponds to the aftermath of Lehman's bankruptcy and is the point of your graph where both GDP and inflation reach their lowest points - but didn't both of them continue to fall afterwards?
- I'm not sure I understand why you consider state-sponsored interventions to cause the crowding out of private agents. I dont think private agents are being forced out of the market by the state - in fact, i think that the fact that the state is the only entity willing to undertake massive investments during a crisis (or simply doing whatever it must to restore credibility) will have the opposite effect and attract some private firms that would, otherwise, not be in operation.
Cheers!
Ok!
ReplyDeleteI get what you are saying, and agree to a large extent. 2 long (sorry...) comments:
First, regarding the bankrupcy of Lehman, in my mind the graph did not represent the immediate (overnight) consequences of the bankrupcy, but rather the long run consequences. So for me, the bankrupcy of lehmand would be somewhere between B and C, with the rest of the distance, being the aftermath in terms of freezing of credit markets and trade loss.You are right, if it were so, the graph would be incorrect... I don't know if you think that that's a decent explanation. It seems to me that to be more correct I should could have included a number of intermediate points between B and C. I guess from B to B1, the money supply would shrink with the disappearance of Lehman's assets and from B1 to B2 (private)Money supply would decrease even more, as all Lehman related assets disappear from everyone's balance sheets. Another hypothetical intermediate point, B3, would then be the result of the velocity of money decreasing to zero for a bit (to think about money markets in a Friedman way), as the opacity of the financial market makes it impossible to understand what's a good asset and what is a bad one, and the scarcity of money increases the relative losses assciated with risk (in this sense higher interest rates in the €zone could indeed have exacerbated the crisis a bit). I mean, since we're on a roll, then I should also have a point C4 caused by a decrease in consumption caused by the drying of finance, which closes businesses, increases unemployment and decreases income. Then the final point C would be the result of actual physical trade also decreasing, because the import/export markets can no longer access the funds for advance payments, and because imports decrease everywhere with a decrease in income.
Second, regarding the public deficits, it's my understanding that when the economy is doing well, then government deficits crowd out private investment, because if there's a fixed amount of investment to be used by the market then coetris paribus, when the government intervenes, it is trying to take away a piece of the cake. Because public debt is a fairly safe asset, there tends to be some crowding out of the private sector by the public sector. It's not an enormous amount of crowding out. I am not saying that they eat all the cake, but they do eat some, which logically implies that there is less to be had by the private sector. Now this is, as I said, during good times. In bad times, I guess one of two things happen: Either the markets take savings (broadly speaking) and make bad investments or when the risk is high, investors lack liquidity or become risk averse and get scared and refuse to lend to each other; right? My understanding is that that's what happened after the Lehman bankrupcy: bad assets crowded out good assets.
Now, my perception is that the private sector has largely recovered from the crisis and is once again able to reinvest efficiently. The state performed its task of intervening and spreading risk to all tax payers when risk was too high, but now that things have regained some sense of normality, it is necessary to withdraw and let the market do it's thing until the next crisis comes along. So I think the state should withdraw (to an extent proportional to the quality of the market). My underlying assumption behind this is that in developed and well regulated economies, the private sector is a better (paretto efficient) investor than the state, which implies that under "normal circumstances" the private sector provides more sustainable economic growth than the state. As such the only reason why I'm advocating for the public sector to leave is because it is not particularly good at ensuring growth, which is a desireable goal in and of itself (although not a suficient one).
What do you think?