A theory of business cycles
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.
Volume (Year): 9 (1996)
Issue (Month): 2 (Autumn)
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