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The Role of Default in Macroeconomics

  • Charles A. E. Goodhart

    (Norman Sosnow Professor of Banking and Finance, London School of Economics (email: c.a.goodhart@lse.ac.uk))

  • Dimitrios P. Tsomocos

    (Said Business School, University of Oxford (email: Dimitrios.Tsomocos@sbs.ox.ac.uk))

What is the main limitation of much modern macro-economic theory, among the failings pointed out by William R. White at the 2010 Mayekawa Lecture? We argue that the main deficiency is a failure to incorporate the possibility of default, including that of banks, into the core of the analysis. With default assumed away, there can be no role for financial intermediaries, for financial disturbances, or even for money. Models incorporating defaults are, however, harder to construct, in part because the representative agent fiction must be abandoned. Moreover, financial crises are hard to predict and to resolve. All of the previously available alternatives for handling failing systemically important financial institutions (SIFIs) are problematical. We end by discussing a variety of current proposals for improving the resolution of failed SIFIs.

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Paper provided by Institute for Monetary and Economic Studies, Bank of Japan in its series IMES Discussion Paper Series with number 11-E-23.

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Date of creation: Sep 2011
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Handle: RePEc:ime:imedps:11-e-23
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