"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Tuesday, May 18, 2010

Really great links - Financial market frictions - Fiscal policy - Wounded Ireland

Narayana R. Kocherlakota - Modern Macroeconomic Models - "In the preceding section, I have emphasized the development of macro models with financial market frictions, such as borrowing constraints or limited insurance. As far as I am aware, these models are not widely used for macro policy analysis. This practice should change. From August 2007 through late 2008, credit markets tightened (in the sense that spreads spiked and trading volume fell). These changes led—at least in a statistical sense—to sharp declines in output. It seems clear to me that understanding these changes in spreads and their connection to output declines can only be done via models with financial market frictions. Such models would provide their users with explicit guidance about appropriate interventions into financial markets."

Narayana R. Kocherlakota - Fiscal policy - " In terms of fiscal policy (especially short-term fiscal policy), modern macro modeling seems to have had little impact. The discussion about the fiscal stimulus in January 2009 is highly revealing along these lines. An argument certainly could be made for the stimulus plan using the logic of New Keynesian or heterogeneous agent models. However, most, if not all, of the motivation for the fiscal stimulus was based largely on the long-discarded models of the 1960s and 1970s. Within a New Keynesian model, policy affects output through the real interest rate. Typically, given that prices are sticky, the monetary authority can lower the real interest rate and stimulate output by lowering a target nominal interest rate. However, this approach no longer works if the target nominal interest rate is zero. At this point, as Gauti Eggertsson (2009) argues, fiscal policy can be used to stimulate output instead. Increasing current government spending leads households to expect an increase in inflation (to help pay off the resulting debt). Given a fixed nominal interest rate of zero, the rise in expected inflation generates a stimulating fall in the real interest rate. Eggertsson’s argument is correct theoretically and may well be empirically relevant. However, the usual justification for the January 2009 fiscal stimulus said little about its impact on expected inflation."

Morgan Kelly - Whatever happened to Ireland? - "Ireland is like a patient bleeding from two gunshot wounds. The Irish government has moved quickly to stanch the smaller, fiscal hole, while insisting that the litres of blood pouring unchecked through the banking hole are “manageable”. Capital markets may not continue to agree for long, triggering a borrowing crisis which will start, most probably, with a run on Irish banks in inter-bank markets.
        Ireland may therefore present an early test of the EU bailout fund. However, in contrast to Greece, Ireland’s woes stem almost entirely from its banking system, and could be swiftly and permanently cured by a resolution which shares the losses of Irish banks with the holders of their €115 billion of bonds through a partial debt for equity swap."

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