Christian R. Proaño

Stabilizing an Unstable Economy: On the Choice of Proper Policy Measures

Currently, many monetary and fiscal policy measures are aimed at preventing the financial market meltdown that started in the US subprime sector and has spread worldwide as a great recession. Although some slow recovery appears to be on the horizon, it is worthwhile exploring the fragility and potentially destabilizing feedbacks of advanced macroeconomies in the context of Keynesian macro models. Fragilities and destabilizing feedback mechanisms are known to be potential features of all markets — the product markets, the labor market, and the financial markets. In this paper we in particular focus on the financial market. We use a Tobin-like macroeconomic portfolio approach, and the interaction of heterogeneous agents on the financial market to characterize the potential for financial market instability. Though the study of the latter has been undertaken in many partial models, we focus here on the interconnectedness of all three markets. Furthermore, we study the potential that labor market, fiscal and monetary policies have to stabilize unstable macroeconomies. Besides other stabilizing policies we in particular propose a countercyclical monetary policy that sells assets in the boom and purchases assets in recessions. Modern stability analysis is brought to bear to demonstrate the stabilizing effects of those suggested policies.

INCOME DISTRIBUTION, CREDIT RATIONING AND HOUSEHOLDS' DEBT

In this paper, we present a model of an economy with household debt, and discuss the conditions under which financial fragility arises. Financial instability is driven by distributive effects. In addition to the income transfers associated with interest payments, the accumulation of debt feeds back with the distribution of income between labour and capital. The model also gives a central role to banks and credit rationing. Contrary to the existing literature, credit supply does not depend on the characteristics of borrowers, but on those of banks. There is a feedback channel between the health of the financial system and the quantity of credit in the economy. We show that there is a diversity of channels through which financial fragility may arise. We identify three channels: a debt–deflation effect a la Fisher, a credit‐financed consumption boom and an exhilarating debt effect.

Dissecting the financial cycle with dynamic factor models

The analysis of the financial cycle and its interaction with the macroeconomy has become a central issue for the design of macroprudential policy since the 2007–08 financial crisis. This paper proposes the construction of financial cycle measures for the US based on a large data set of macroeconomic and financial variables. More specifically, we estimate three synthetic financial cycle components that account for the majority of the variation in the data set using a dynamic factor model. We investigate whether these financial cycle components have significant predictive power for economic activity, inflation and short-term interest rates by means of Granger causality tests in a factor-augmented VAR set-up. Further, we analyze whether the synthetic financial cycle components have significant forecasting power for the prediction of economic recessions using dynamic probit models. Our main findings indicate that all financial cycle measures improve the quality of recession forecasts significantly. In particular, the factor related to financial market participants’ uncertainty and risk aversion—related to Rey’s (2013) global financial cycle—seems to serve as an appropriate early warning indicator for policymakers.

Stock‐Flow Interactions, Disequilibrium Macroeconomics and the Role of Economic Policy

This paper presents the ‘KMGT’ (Keynes–Metzler–Goodwin–Tobin) portfolio model and studies its stability properties. The approach to macrodynamic modelling taken here extends the KMG model of Chiarella and Flaschel (2000), focusing in particular on the incorporation of financial markets and policy issues. The original KMG model considered three asset markets (equities, bonds and money) but depicted them in a rudimentary way so that they had little influence on the real side of the model. The only financial market influencing the real side of the economy was the money market (via an LM curve theory of interest). Here Tobins portfolio choice theory models the demand for each asset in such a way that the total amount of assets that households want to hold equals their net wealth, which is a stock constraint attached to portfolio choice. There is also a flow constraint, that the net amount of assets accumulated (liabilities issued) by one sector must equal its net savings (expenditures). The Tobinian macroeconomic portfolio approach characterizes the potential for financial market instability, focusing on the interconnectedness of all three markets. The paper goes on to study the potential for labour market and fiscal policies to stabilize unstable macroeconomies.

AS-AD Disequilibrium Dynamics and the Taylor Interest Rate Policy Rule: Euro Area-Based Estimation and Simulation

The future and the success of the European Monetary Union are still unclear in many respects. While some researchers think that monetary unification, with the subsequent higher economic integration and labour mobility between the EMU member countries, will lead to a synchronization of the business cycles of the participating economies, and therefore to a more harmonic macroeconomic environment within the EMU, other observers see great dangers for its stability and even its further existence, due to the present scenario of (competing) heterogeneous fiscal policies and the (non-cooperative) inflation developments in certain economies. In any case, even if such destabilizing factors decrease in the years ahead, the stability of the EMU depends to a large extent on the proper conduct of monetary policy by the ECB and the resulting changes in economic activity and in nominal wage and price adjustment in the EMU in particular.

Monetary Policy Rules and Macroeconomic Stabilization in Small Open Economies Under Behavioral FX Trading: Insights from Numerical Simulations

In this paper the interaction between foreign exchange (FX) markets driven by trading based on behavioral forecasting rules and the macroeconomy of a small open economy is investigated. A special focus of the paper is set on the consequences of chartism or technical analysis for the stability at the macroeconomic level. Furthermore, the performance of alternative monetary policy rules concerning the overall stabilization of the economy is investigated through numerical analysis.

The J2 Status of Chaos in Period Macroeconomic Models

We reconsider the issue of the (non-)equivalence of period and continuous time analysis in macroeconomic theory and its implications for the existence of chaotic dynamics in empirical macroeconomics. We start from the methodological precept that period and continuous time representations of the same macrostructure should give rise to the same qualitative outcome, i.e. in particular, that the results of period analysis should not depend on the length of the period chosen. A simple example where this is fulfilled is given by the Solow growth model, while all chaotic dynamics in period models of dimension less than 3 are in conflict with this precept. We discuss a typical example from the recent literature, where chaos results from an asymptotically stable continuous-time macroeconomic model when it is reformulated as a discrete-time model with a sufficiently long period length.

Escape routes from sovereign default risk in the euro area

The recent financial and sovereign debt crises around the world have sparked a growing literature on models and empirical estimates of defaultable debt. Frequently households and firms come under default threat, local governments can default, and recently sovereign default threats were eminent for Greece and Spain 2012-13. Moreover, Argentina experienced an actual default in 2001. What causes sovereign default risk, and what are the escape routes from default risk? Previous studies such as Arellano (2008), Roch and Uhlig (2013) and Arellano et al. (2014) have provided theoretical models to explore the main dynamics of sovereign defaults. These models can be characterized as threshold models in which there is a convergence toward a good no-default equilibrium below the threshold and a default equilibrium above the threshold. However, in these models aggregate output is exogenous, so that important macroeconomic feedback effects are not taken into account. In this paper, we 1) propose alternative model variants suitable for certain types of countries in the EU where aggregate output is endogenously determined and where financial stress plays a key role, 2) show how these model variants can be solved through the Nonlinear Model Predictive Control numerical technique, and 3) present some empirical evidence on the nonlinear dynamics of output, sovereign debt and financial stress in some euro area and other industrialized countries.

Macroeconomic Risk, Fiscal Policy Rules and Aggregate Volatility in Asymmetric Currency Unions: A Behavioral Perspective

This paper studies the dynamics of macroeconomic risk, fiscal policy and the macroeconomy in a two-country monetary union framework, under the assumption that agents do not have rational expectations, but use heuristics to determine their consumption over time, as well as to assess macroeconomic risk. Further, the macroeconomic consequences of a divergence between the design of fiscal policy and the behavioral perception of macroeconomic risk by the financial markets are investigated using numerical simulations. Among other things, these simulations show that an extreme focus on debt stabilization can be counterproductive if the financial markets care more about other indicators, such as the countrys output gap or external imbalances.

Expectations, Firms’ Indebtedness and Business Fluctuations in a Structural Keynesian Monetary Growth Framework

In this contribution we incorporate the main elements of the small-scale firms’ debt-finance model by Franke and Semmler (1989) into a medium-scale disequilibrium macroeconomic framework along the lines of Chiarella, Flaschel and Franke (2005). In a fully interdependent model incorporating investing firms, savings of rentier households, commercial banks and the government, the endogenously generated debt of firms (created through borrowing) feeds back dynamically to the investment behaviour of firms, their borrowing of funds, the asset market, the interest rate and the expected rate of return (representing the confidence of investors with regard to future development). The impact of debt-financing of firms on aggregate economic activity and its stability will be studied within this context. We also investigate the dynamics of the resulting model by means of numerical simulations.