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A Student’s Guide to the Current Economic Crisis

Dave ColanderMiddlebury College

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Outline of Talk

Provide a bit of history of macroeconomics

Discuss how the AS/AD model can be used to explain the current crisis

Discuss why the crisis is scary and the government’s attempt to get us out of the crisis.

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The Macro Economy as a complex system

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Some Macro History Macroeconomics as a course developed in

the 1930s Before then, the was Classical economics,

and quantity theory of money Macroeconomics became associated with

Keynesian economics and a specific limited interpretation of Keynesian economics

Keynesian economic theory was soon sidetracked into simple equilibrium models that didn’t capture possible dynamic instability.

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Explaining the current crisis in words Structural economy changed in 1990s—

inflation ended due to global competition Government expanded money supply; private

sector expanded leverage. Bubbles in asset markets were created by

leverage and expectations. Not noticed because there was no goods

market inflation Nominal wealth increased more than real

wealth could. People had irrational exuberance and expectations.

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Causes of the Current Crisis

Too Easy Monetary Policy Too Easy regulation Too strong reliance on models and

past history

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Explaining the Current Crisis in the AS/AD Model

The Use and Abuse of the AS/AD model The one thing at a time approach

What’s being held constant? Standard Story is an equilibrium

story What’s missing? Dynamic

disequilibrium problems

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The Dynamic Disequilibrium Story: When Other Things Don’t Remain Constant

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Explaining the Current crisis in a Picture

A 450 pound 5 ft 10 inch man has a heart attack.

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Explaining the Current Crisis in the Quantity Theory

MV = PY

Global competition changed the connection; asset price bubble

Failure to distinguish between real wealth and nominal wealth

Money no longer the relevant issue—the quantity theory of credit.

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Government Response to the Crisis

Triage Policy Treatment Policy Rehabilitation

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Triage Policy

Why is the financial sector different. It is the economic equivalent to the heart.

If the financial sector stops beating, the economy stops.

The Troubled Asset Rescue Package (TARP)—the 700 billion triage policy. Keep the financial sector going.

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Treatment policy

Monetary policy Liquidity trap Quantitative easing

Fiscal policy Fiscal stimulus Automatic stabilizers

Expectations policy

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Rehabilitation Stage

Repairing the Damage Done in the Triage and Treatment Stage Eliminating the Deficit Creating a sense of fairness Countering the sense of unfairness from the

bailout programs. Too big to fail and the moral hazard

problem The Problem waiting in the Wings:

International Financial Crisis Trade deficit Dollar overhang

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Three Ideas to Keep in Mind in Structuring new Regulation The golden rule of economics: Him

who has the money makes the rules. If you will bail out, you have to

regulate; avoid the moral hazard problem

Law of Diminishing Regulation: Technological change and leaning by sneaking around undermines regulation