Question

Using the New Keynesian model framework, try to use the model to explain the Great Recession, also include in the model the affects of the Monetary and Fiscal Policy pursued by the Federal Reserve and Federal Government, respectively. How would does your explanation change when using the Real Business Cycle model?

Answer 1

The model attributes all three downturns to a similar mix of aggregate demand and supply disturbances. The most recent series of adverse shocks lasted longer and became more severe, however, prolonging and deepening the great recession. In addition, the zero lower bound on the nominal interest rate prevented monetary policy from stabilizing the US economy as it had previously; counterfactual simulations suggest that without this constraint, output would have recovered sooner and more quickly in 2009.

No matter what happens next, this seems safe to say: that the recession of 2007 through 2009 will always be remembered for its extreme severity. By many measures, in fact, it appears even now as the worst downturn the US economy has experienced since the Great Depression. It brought to an abrupt close the relatively tranquil period, lasting more than twenty years, that had become known as the “great moderation.” And for all these reasons, it deserves a special name of its own: the “great recession” of 2007-09. Indeed, the extreme severity of this great recession makes it tempting to argue that new theories are required to fully explain it. And given the prominence of the financial institutions whose solvency and liquidity problems grabbed and held the newspaper headlines as the broader economic crisis deepened, it is tempting to single out those solvency and liquidity problems as chief among the fundamental factors causing the recession itself. But while, on the bright side, the extreme volatility in financial markets and across the economy as a whole surely has generated action in the data that will be useful in extending macroeconomic theory going forward, two sets of considerations suggest that it would be premature to abandon more familiar models just yet. First, banking failures and liquidity dry-ups seldom occur as totally exogenous events; this time around, they stemmed from problems in real estate markets that, themselves, undoubtedly reflect more basic macroeconomic fundamentals. Attempts to explain movements in one set of endogenous variables, like GDP and employment, by direct appeal to movements in another, like asset market valuations or interest rates, sometimes make for decent journalism but rarely produce satisfactory economic insights. Second, recessions have always been accompanied by an increase in bankruptcies among financial and nonfinancial firms alike, and one recent recession, in 1990-91, also featured systemic problems in banking that wiped out the savings and loan industry as a major segment of the US financial sector just as, today, the future of the investment banking industry has been thrown into doubt

The analysis suggests, in fact, that the 2007-09 recession has its origins in a combination of aggregate demand and supply disturbances that resembles quite closely the mix of shocks that set off the previous two downturns. The main difference is that for the most recent recession, the series of adverse shocks lasted much longer and became much larger; hence, the effects of that series of shocks lasted much longer and became much more severe as well. The analysis does point to another difference, however, relating to the zero lower bound on the nominal interest rate. This constraint on monetary policy became binding during 2007-09 recession, though not before. And the estimated model suggests that because of this constraint, monetary policy became quite restrictive, especially during 2009, contributing both to the length and severity of the downturn. By contrast, expansionary monetary policy helped, at least somewhat, in cushioning the US economy against the adverse shocks that hit during 1990-91 and 2001. Altogether, these results deepen our understanding of recent US economy history. They point to systematic aspects of US monetary policy that might be reconsidered in light of that recent history. And they speak to the continued relevance of the New Keynesian model, perhaps not as providing the very last word on but certainly for offering up useful insights into, both macroeconomic analysis and monetary policy evaluation

Keynesians do not think that the typical level of unemployment is ideal—partly because unemployment is subject to the caprice of aggregate demand, and partly because they believe that prices adjust only gradually. In fact, Keynesians typically see unemployment as both too high on average and too variable, although they know that rigorous theoretical justification for these positions is hard to come by. Keynesians also feel certain that periods of recession or depression are economic maladies, not, as in real business cycle theory, efficient market responses to unattractive opportunities.

there was the European depression of the 1980s, the worst since the depression of the 1930s. The Keynesian explanation is straightforward. Governments, led by the British and German central banks, decided to fight inflation with highly restrictive monetary and fiscal policies. The anti-inflation crusade was strengthened by the European monetary system, which, in effect, spread the stern German monetary policy all over Europe. The new classical school has no comparable explanation. New classicals, and conservative economists in general, argue that European governments interfere more heavily in labor markets (with high unemployment benefits, for example, and restrictions on firing workers). But most of these interferences were in place in the early 1970s, when unemployment was extremely low.

The standard view of a depression is that it constitutes a particular phase in the business cycle, characterized by the fact that output remains (significantly) below the trend line. In turn, a business cycle is defined as being composed of four elements: the depression or decline, the trough, the recovery and the peak. In short, a business cycle is a set of peak-to-trough movements. To Cole and Ohanian, the Great Depression is yet another depression, its uniqueness lying solely in its amplitude. Lucas (1977: 218) claims that the fact that all business cycles manifest the same sequence of movements and time lags is the very feature that allows a general theory of the business cycle, abstracted from the particularities of individual cycles, to be constructed. This is why this literature gives so little attention to the causes of any given depression It remains true, nonetheless, that all business cycles – and their components – are a mix of singularity and recurrence. Real business cycle theory just assumes that the singularity dimension can be overlooked for the sake of theoretical analysis. So the appropriateness of applying the real-business-cycle toolbox to the Great Depression hinges on the assumption that in this episode too the recurrence is more important than the singularity. If the reverse is true, the appropriateness of the business cycle framework for tackling the Great Depression has to be questioned. The alternative viewpoint is that the Great Depression was not a depression in the standard sense (i.e. in the sense that slumps are necessarily followed by recoveries after some “liquidation” has come to an end). A system-failure phenomenon, analogous to that which occurred with the downfall of the former communist regimes, may have been at work. In this view, the 1929-33 events brought the economy to a state of affairs where any speedy recovery through private-sector adjustments was excluded. To vanquish the threat of a system collapse, a strong signal announcing a change in regime was needed

The devaluation of the dollar [by the Roosevelt administration] was the single biggest signal that the deflationary policies implied by adherence to the gold standard had been abandoned, that the iron grip of the gold standard had been broken. Devaluation had effects on prices and production throughout the economy, especially on farm and commodity prices, not simply on exports and imports. It sent a general message to all industries because it marked a change in direction for government policies and for prices in general. The elements of the New Deal emerged in the course of 1933; the devaluation of April-July 1933 was the proximate cause of the recover