Peter Flaschel

Keynesian Disequilibrium Dynamics: Convergence, Roads to Instability and the Emergence of Complex Business Fluctuations

We reformulate the traditional AS-AD growth model of the Neoclassical Synthesis (stage I) with a Taylor policy rule replacing the conventional LM-curve, with gradually adjusting wages as well as prices, and with perfect foresight on current inflation rates and an adaptively revised notion of an inflationary climate in which the economy is operating. We compare this approach with the New Keynesian approach, the Neoclassical Synthesis, stage II, with staggered price and wage setting and find various common components, yet with radically different dynamic implications due to our treatment of the forward-looking part of our wage-price spiral. We show for a system estimate of our model that it implies qualitatively local asymptotic stability and when its estimated form is simulated in response to isolated shocks strongly damped business fluctuations, due to a stable interaction of goods market dynamics with the interest rate policy of the central bank and due to a normal working of a real-wage feedback chain. These results are however endangered – leading in fact to economic breakdown – when there is a global floor to money wage inflation rates. In this case, the return of some money wage flexibility in deep depressions is of help in restoring viability of the model, thereby even avoiding explosive dynamics and the collapse of the economy. This situation leads to viable, but complex business fluctuations.

Financial Assets, Debt and Liquidity Crises: A Keynesian Approach: Bankruptcy of firms, debt default and the performance of banks

List of figures List of tables Notation Preface 1. Financial crises and the macroeconomy Part I. The Nonlinear Dynamics of Credit and Debt Default: 2. Currency crises, credit crunches and large output loss 3. Mortgage loans, debt default and the emergence of banking crises 4. Debt deflation and the descent into economic depression Part II. Theoretical Foundations for Structural Macroeconometric Model Building: 5. Keynesian macroeconometric model building: a point of departure 6. Intensive form and steady state calculations 7. Partial feedback structures and stability issues Part III. Debt Crises: Firms, Banks and the Housing Markets: 8. Debt deflation: from low- to high-order macrosystems 9. Debt default, bankruptcy of firms, and banks performances 10. Japans institutional configuration and its financial crisis 11. Housing investment cycles, workers debt and debt default Bibliography.

Foundations for a Disequilibrium Theory of the Business Cycle: The Keynes–Metzler–Goodwin model

Building on The Dynamics of Keynesian Monetary Growth by Chiarella and Flaschel (2000), this book is a key contribution to business cycle theory, setting out a disequilibrium approach with gradual adjustments of the key macroeconomic variables. Its analytic study of a deterministic model of economic activity, inflation and income distribution integrates elements in the tradition of Keynes, Metzler and Goodwin (KMG). After a qualitative analysis of the basic feedback mechanisms, the authors calibrate the KMG model to the stylized facts of the business cycle in the U.S. economy, and then undertake a detailed numerical investigation of the local and global dynamics generated by the model. Finally, topical issues in monetary policy are studied in small macromodels as well as for the KMG model by incorporating an estimated Taylor-type interest rate reaction function. The stability features of this enhanced model are also compared to those of the original KMG model.

Output, Interest and Changing Exchange Rate Regimes

We now enter into the later phase of the Bretton Woods system, broadly speaking from the midst of the sixties up to 1973 when the Bretton Woods system came to an end. This period was characterized by significantly increasing capital flows, speculative exchange rate attacks and also real disturbances. The model used at the time to understand the evolution in international trade in goods and financial assets was the so-called Mundell-Fleming model, based on works of Mundell and Fleming in the early 1960s.1 Yet, though the basic Mundell-Fleming approach is now surely outdated, modern variants of this approach (of the IS-LM-PC type) still have their place in the literature on fiscal and monetary policy in open economies, at the very least as a point of reference for other contemporary approaches that stress intertemporal aspects, no-arbitrage conditions as representations of asset market equilibria and rational capital gains expectations; see McKibbin and Sachs (1991) for an example. It is therefore still of use to start from and to consider the basic form of the Mundell-Fleming approach to trade and capital mobility, its rich set of implications for the use of fiscal and monetary policy under various central banking and exchange rate regimes and its eventual evolution towards a more complete and coherent IS-LM-PC approach, including exchange rate dynamics, to the understanding the economic interactions in the world economy.

Small Open KMG Economies: Australia and the Murphy model

We investigate in this chapter1 an integrated DAS-DAD growth model of a small open economy with sluggish price and quantity adjustments and thus disequilibrium both in the labor and in the goods market. We integrate the real dynamics of Goodwin and Rose type employment cycles, an inflationary dynamics of Tobin (1975) type, Metzlerian inventory dynamics — as introduced in Chiarella and Flaschel (2000a, ch.6) — now with Dornbusch’s exchange rate dynamics (see chapter 5 of this book). This now implies eight laws of motion, two for each of the subdynamics. These intrinsically nonlinear 8D-dynamics are asymptotically stable with respect to a uniquely determined interior steady state solution, broadly speaking, for low adjustment speeds of prices and expectations (and inventories) and give rise to Hopf-bifurcations as these adjustment parameters are increased, leading furthermore to cyclically explosive behavior thereafter. Two extrinsic nonlinearities are then added to the dynamics, one in capital flows (in the degree of capital mobility) and the other a kink in the money wage Phillips curve of the model. These two nonlinearities radically modify the explosive tendencies of the dynamics, restricting them to economically meaningful domains even for fairly extreme choices of parameter values.

Two-Country Business Cycle Models: ‘Euroland and the USA’

In this final chapter of the book we reformulate and extend the analysis of small open economies of chapters 8 and 9 towards some initial theoretical considerations and some numerical explorations of the case of two interacting large open economies like Euroland and the USA.1 However we shall here reconsider primarily simplified (compared to 14D KMG dynamics) 10D open KWG growth and inflation dynamics. Such dynamics were already considered from the enlarged perspective of open economies in appendix 1 of chapter 8 for the case of a small open economy. We consider the 10D KWG dynamics first analytically, in order to derive again various stability propositions, including those concerning the occurrence of cyclical loss of stability by way of Hopf bifurcations, and then numerically for closed as well as interacting KWG economies in order to see their business cycle implications separately and then in interaction. The results achieved in this closing chapter still represent work in progress and thus surely need extension in order to truly judge the potential of the proposed model type for a discussion of the international transmission of the business cycle through positive or negative phase synchronization and other important topics of the literature on coupled oscillators of economic as well as of other origin.2

KMG Model Building: The Baseline Case of a ‘Closed’ US-Economy

In this chapter we start the investigation of a model type that not only allows for sluggish wage, but also for sluggish price and quantity adjustments, implying in particular over- or underutilized labor as well as capital in the evolution of the economy and a resulting real wage dynamics that allows for a variety of stability scenarios with respect to the role of income distribution.1 We thus depart significantly from the conventional IS-LM-PC analysis of the part I of the book which there provided the basis for an elaborate Dornbusch type open economy macrodynamics. We will integrate this exchange rate dynamics later on into the now considered type of macrodynamics, in chapters 8 – 10 of the book, after an application of the closed economy model of this chapter to a large open economy within a fixed exchange rate area, in chapter 7, where the focus is still on trade in commodities and not yet on trade in financial assets. As an example for the closed economy macrodynamics that follows we consider, as the title of this chapter indicates, the US-economy in the period following World War II. The here presented model of a closed economy has indeed successfully been applied to and estimated for the US-economy for U.S. time series data 1960.1–1995.1 in Flaschel, Gong and Semmler (2001), see section 3 below for a brief summary of their results. This model may therefore be considered a valid first approximation in an attempt to model the US-economy on the basis of sluggish wage, price and quantity adjustments and fluctuating rates of capacity utilization for both labor and capital, see also Obstfeld and Rogoff (2001, p.172) who state there ‘that the US-economy still remains a surprisingly closed economy’.2

The Closed Economy: The Frisch or Keynes Paradigm?

In this chapter we provide, as an introduction into the essential features of our approach to open economy macrodynamics, two different views of the working of modern market economies on the macrolevel,1 the Neoclassical and the Keynesian approaches which indeed give rise to very different macrodynamic implications,2 even on the standard IS-LM-PC textbook level of macrodynamic modelling that includes the Phillips Curve (PC) mechanism. We shall show that basic systematically destabilizing feedback chains in this standard framework are generally simply ignored or — if taken note of — restricted to short discussions of basically comparative static analysis (e.g. on the adverse effects of deflation, Blanchard, 2003, p.408) or solely put into exercises (e.g. on destabilizing price flexibility, Romer, 1996, p.239). By contrast, we will show in this chapter that such destabilizing feedback mechanisms form an integral part of any proper Keynesian IS-LM-PC analysis in periods of inflation, even more than in periods of deflation. The relevance of these can eventually only be decided by an empirical analysis concerning the parameter sizes of the model for certain historical episodes and specific countries.

Classical Two-Country Dynamics: Pure Price Adjustments?

In this chapter we formulate and investigate international trade in a two-country world producing a common commodity (and later on differentiated commodities), with fully employed resources in both countries and with the specie flow mechanism to which international trade necessarily gives rise under the rules of the gold standard. This mechanism represents the most basic possibility for integrating international capital flows into a consistent reflection of, and in interaction with, what happens on the real side of the considered economies. We primarily investigate an exchange rate regime with exchange rates fixed by the rules of the gold standard, coupled with perfectly flexible prices and perfect international competition, represented by the law of one price or the Purchasing Power Parity (PPP) condition in its absolute form. The associated extremely Classical theory of aggregate demand moreover, is chosen in as simple a way as possible and is given by a straightforward reinterpretation of the quantity theory of money as a theory of goods demand.

Large Open KMG Economies: Germany within the EMU

In this chapter we extend the framework of the preceding chapter towards the inclusion of international trade in commodities.1 We consider a large open economy like Germany in an international environment with fixed exchange rates like Euroland, in order to study two way trade in commodities between ‘Germany’ and the rest of ‘Euroland’, first with German money supply determining the interest rate in ‘Euroland’. Here we also consider pass-through effects of the foreign rate of inflation on the domestic one. In later parts of the chapter we will again consider Taylor type interest rate policy rules and this as well as the earlier scenarios with respect to implications for asymptotic stability, cyclical loss of stability by way of Hopf-bifurcations and more, when the adjustment speeds of the considered economy become sufficiently high.