Has Anybody Successfully Taught the Financial Crisis as a Freshman Seminar Yet?
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Notes on the Two Standard Theories of Macroeconomics...

Keynesian:

  • When spending is less than incomes, inventories pile up, firms fire people, and incomes fall until spending equals incomes.
  • When spending is greater than incomes, inventories fly off the shelves, firms hire, people, and incomes rise until incomes equal spending.
  • Prices and wages are somewhat "sticky" and so fluctuations in spending and incomes show up in the "short run" primarily as fluctuations in production and employment and not as fluctuations in wage and price levels.
  • Spending depends on incomes, confidence, and interest rates
  • Spending comes in four categories: consumption spending C by households, investment spending I by businesses seeking to add to their capacity, government purchases G, and net exports NX.
  • Using the national income identity:
    • C = c0 + (cy x Y): consumption depends on consumer confidence, on the marginal propensity to consume, and on incomes.
    • I = I0 + (Iy x Y) - (Ir x r): business investment depends on business animal spirits, on whether strong demand is putting pressure on capacity, and on the interest sensitivity of investment times the long-term risky real interest rate r.
    • G
    • NX
    • Y = C + I + G + NX
    • Y = [c0 + G + NX + I0 - (Ir x r)]/[1 - cy - Iy]

Monetarist:

  • When the money stock is too low given the level of velocity, people cut back on spending, inventories pile up, firms fire people, and incomes fall.
  • When the money stock is too high given the level of velocity, people increase spending, inventories fly off the shelves, firms hire people, and incomes rise.
  • Prices and wages are somewhat "sticky" and so fluctuations in spending and incomes show up in the "short run" primarily as fluctuations in production and employment and not as fluctuations in wage and price levels.
  • Using the quantity theory of money
    • Y = (M/P) x V: real spending equals the real money stock times velocity
    • V = v0 + (vi x i): velocity is equal to a baseline term times the interest sensitivity of velocity times the short-term safe nominal interest rate i.
    • Y = (M/P) x v0 + ((M/P) x vi x i)

Note that neither of these theories seems to have an obvious central role for financial markets--financial markets feed each of these models an interest rate--the long-term risky real interest rate r in the Keynesian model, and the short-term safe nominal interest rate i in the monetarist model.

Which of these theories is correct? Both--they are both (nearly) tautologies...

Which of these theories is most useful in understanding the coming of the Great Recession Little Depression of 2007-2012? Neither--for all the action goes on behind the scenes, in the determination of I0 and r in the Keynesian model and in the determination of v0, vi, M, and in the monetarist model.

How, then, should we analyze the coming of the Great Recession Little Depression of 2007-2012 at a freshman seminar level?


####DRAFT: U.C. Berkeley: Fall 2011: Economics 24-1: The Financial Crisis and the Great Recession Little Depression of 2007-2012####

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