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A theory of business cycles

  • Roger E. A. Farmer

    (Department of Economics, University of California)

This paper constructs a complete dynamic general equilibrium model of a macroeconomy that is similar in many respects to the IS/LM model that dominated the thinking of most macroeconomists for a generation. Unlike the IS/LM model all markets are modeled as in equilibrium at all points in time. Since the model is set in an overlapping generations structure in which there is incomplete participation in insurance markets, we are able to model business fluctuations that are driven by the self-fulfilling beliefs of investors. These fluctuations are Pareto inefficient since agents are risk averse and would prefer a non-stochastic allocation to an allocation that fluctuates. Our model is in contrast to the real business cycle approach that also uses a general equilibrium model but in which all fluctuations are Pareto efficient. Since the framework of our model is a complete intertemporal maximizing model we are able to explain why there may be a role for government in stabilizing business fluctuations.

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Article provided by Finnish Economic Association in its journal Finnish Economic Papers.

Volume (Year): 9 (1996)
Issue (Month): 2 (Autumn)
Pages: 91-109

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Handle: RePEc:fep:journl:v:9:y:1996:i:2:p:91-109
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  1. Jordi GalĂ­, 1993. "Monopolistic competition, business cycles and the composition of aggregate demand," Economics Working Papers 45, Department of Economics and Business, Universitat Pompeu Fabra.
  2. Farmer, Roger E.A. & Woodford, Michael, 1997. "Self-Fulfilling Prophecies And The Business Cycle," Macroeconomic Dynamics, Cambridge University Press, vol. 1(04), pages 740-769, December.
  3. Farmer Roger E. A. & Guo Jang-Ting, 1994. "Real Business Cycles and the Animal Spirits Hypothesis," Journal of Economic Theory, Elsevier, vol. 63(1), pages 42-72, June.
  4. Farmer, Roger E A, 1991. "The Lucas Critique, Policy Invariance and Multiple Equilibria," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 321-32, April.
  5. Mark Gertler & Simon Gilchrist, 1991. "Monetary Policy, Business Cycles and the Behavior of Small Manufacturing Firms," NBER Working Papers 3892, National Bureau of Economic Research, Inc.
  6. Duffy John, 1994. "On Learning and the Nonuniqueness of Equilibrium in an Overlapping Generations Model with Fiat Money," Journal of Economic Theory, Elsevier, vol. 64(2), pages 541-553, December.
  7. Russell Cooper & John Haltiwanger, 1990. "Macroeconomic Implications of Production Bunching: Factor Demand Linkages," Papers 0001, Boston University - Industry Studies Programme.
  8. repec:ubc:bricol:93-34 is not listed on IDEAS
  9. Robert E. Hall, 1986. "Market Structure and Macroeconomic Fluctuations," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 17(2), pages 285-338.
  10. Lawrence J. Christiano & Martin Eichenbaum, 1992. "Liquidity effects, monetary policy, and the business cycle," Discussion Paper / Institute for Empirical Macroeconomics 70, Federal Reserve Bank of Minneapolis.
  11. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  12. Farmer, Roger E. A., 1992. "Nominal price stickiness as a rational expectations equilibrium," Journal of Economic Dynamics and Control, Elsevier, vol. 16(2), pages 317-337, April.
  13. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
  14. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
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