Fifteen years after the Global Financial Crisis: Recessions and Business Cycles in the History of Economic Thought

Tracking Old and New Business Cycles in DSGE models

Ehnts Dirk, Torrens University
Mazzocchi Ronny, European Parliament

Before the 1970s central banking doctrine was mainly concerned with controlling credit cycle to avoid financial crashes and bank panics. Monetary theory of the last fifty years represents a clear break compared to this honoured and ancient approach. Today’s theory, embedded in the DSGE modelling strategy, may have rediscovered the importance of solvency of governments, but has rather lost the solvency of the private sector. In assuming that the economy is always in intertemporal general equilibrium, it in effect assumes away the problems with which older central banking theories sought to cope. In particular, in the DSGE models it is assumed that real interest rates coordinate consumption and production plans to maintain the economy always on the intertemporal efficiency frontier. Within such a conceptual framework, the only sensible function remaining for a central bank is to provide nominal stability by control of the short-term interest rate. Attempts to regulate real activity are as senseless as they are futile. The 2007 Great Financial Crisis have seriously disputed this framework. The prevailing consensus is to consider the crisis as the result of external shocks that could not have been anticipated. However, the crisis did not come from an external shock. Since the mid-90s interest rates were too low, which is not independent from a reduction in government spending and slower wage growth in public and private sector. This has created in several countries what Austrian economists called “intertemporal problem”. In essence what happens is that inappropriately low interest rate bring forward investment spending by households and firms from “tomorrow” to “today” (increasing the demand) so that when “tomorrow” arrives, budget constraints reduce spending at precisely the time when “yesterday’s” investment comes on stream (increasing the supply). Also, DSGE models fail to properly account for the state as a driver of demand and a wage and price setter. Therefore, these imbalances result from failures of interest-rate mechanism to coordinate the plans of investors and savers over time and from a disregard of the state's fiscal stance. In this paper, we aim to propose a modelling framework which is able to capture the effects of investment-saving imbalances by means of modern techniques. This has important consequences in the implementation of monetary policy.

Area: Eshet Conference

Keywords: DSGE models, business cycle. financial crisis, monetary policy

Please Login in order to download this file