The Unassuming Economist

Source: NBER Working Paper

Standard macroeconomic models that explain business cycles in the economy, like the real business cycle or Solow model, usually propound the existence of a momentary economy-wide equilibrium, a long-run steady-state equilibrium, and a unique convergent path to arrive at that steady-state equilibrium. However, in this paper for NBER, economists Tomohiro Hirano and Joseph Stiglitz demonstrate using the life cycle model with production a situation where multiple equilibria can exist. They suggest that this multiplicity of equilibria can give rise to “wobbly macro-dynamics”, i.e. a dynamic situation for the economy wherein it can bounce around infinitely without converging, all the time doing so in ways perfectly consistent with rational expectations. They further go on to add, “this wobbly macro-dynamics is driven by people’s beliefs or sentiments, and doesn’t even have regular periodicity”. “As a result, laissez-faire market economies can be plagued by repeated periods of instabilities, dynamic inefficiencies, and unemployment.”

Source: VoxEU CEPR

“Early signs of a recession can lead to a negative feedback loop, with workers’ concerns about unemployment dampening demand and thus deepening the recession. This column uses a heterogeneous agent model to quantify the importance of the ‘unemployment-risk’ channel for business cycle fluctuations in the US economy. It shows that the channel accounts for around one-third of observed unemployment fluctuations. As the demand amplification through precautionary savings is inefficient, this finding provides an additional rationale for stabilisation policies by policymakers. “

Figure: Estimated response of unemployment to monetary policy and total factor productivity (TFP) shocks

Click here to read the full article.