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Animal Spirits, Persistent Unemployment and the Belief Function

Animal Spirits, Persistent Unemployment and the Belief Function. Duke University, February 2011 Roger E A Farmer Department of Economics UCLA. Main Question. Is the economy self-correcting? Yes Classical economics New-Keynesian economics No Keynes of the General Theory

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Animal Spirits, Persistent Unemployment and the Belief Function

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  1. Animal Spirits, Persistent Unemployment and the Belief Function Duke University, February 2011 Roger E A Farmer Department of Economics UCLA

  2. Main Question • Is the economy self-correcting? • Yes • Classical economics • New-Keynesian economics • No • Keynes of the General Theory • Old-Keynesian economics

  3. The Goals of This Research • Replace New-Keynesian Economics • Why? • Degree of price stickiness is inconsistent with micro evidence • Cannot explain inflation persistence • There is no unemployment in the canonical model • Welfare costs of business cycles are trivial • Cannot explain asset price bubbles • Alternative: Old Keynesian economics

  4. Main Idea • Put in a search model of the labor market • Drop the Nash bargain • Replace the Nash bargain with demand determination of output through self-fulfilling expectations • Costly Search and Recruiting • Externality supports different allocations as equilibria • Animal spirits select an equilibrium

  5. Connection with New-Keynesian Theory • New Keynesian economics assumes sticky prices. Deviations from the natural rate of unemployment are temporary. • Old Keynesian economics assumes flexible prices. There is a continuum of steady state unemployment rates indexed by beliefs.

  6. Connection with Search Theory • Two kinds of multiplicity in search models • Finite multiplicities: Diamond 1982,1984 • Steady state Continuum: Howitt and McAfee 1987 • Continuum follows from bilateral monopoly

  7. A Model • One Lucas tree – non reproducible • One good produced by labor and capital • No disutility of work – everyone wants a job • Everyone fired and rehired every period • No uncertainty

  8. The Labor Market • Finding a job uses resources • Two technologies • Production technology • Matching technology

  9. Terminology Number of trees (Normalized to 1) Time endowment of household (Normalized to 1) Consumption in units of commodities Output in units of commodities

  10. Terminology Money wage Money rental rate Relative price of a tree Money price of a commodity

  11. Terminology Employment Production workers Recruiters

  12. Technologies Production technology Match technology

  13. Planning Problem y L* U* X* V* L L* 1

  14. Decentralizing • Need headhunting firms • Pay unemployed workers • Pay corporate recruiters • Sell matches • We don’t see these markets

  15. More Terminology Probability of a worker being hired One recruiter hires this many workers

  16. Decentralization • Agents take wages and prices as given • Households take hiring probability as given • Firms take hiring effectiveness as given • All markets clear

  17. Firm’s Problem

  18. Firm’s Problem Firm acts like a firm in an auction market but takes q as given q is an externality that represents market tightness. For any given q there is a zero profit equilibrium

  19. Market Tightness • q is an indicator of market tightness • For every value of q there is a different zero profit equilibrium

  20. Comparison with the Classical Model Classical Old Keynesian

  21. The Production Function, Aggregate Supply and Demand Commodities c Dollars (wage units) C Labor Labor Aggregate Supply Production Function

  22. Data Used in This Study I use the output gap instead of unemployment for more direct comparison with new-Keynesian literature

  23. Augmented Dickey-Fuller Tests for a Unit Root in Individual Series Even after taking out a linear trend -- gdp is still extremely persistent. We cannot reject the hypothesis of a unit root in deviations of gdp from trend.

  24. The New-Keynesian Model

  25. The Old-Keynesian Model

  26. Steady States of the Two Models

  27. Estimation • I estimated both models with MCMC in Dynare • For each model I ran 150,000 replications

  28. Comparison of the Two Models

  29. Why? • In the data GDP, the interest rate and inflation are well described by a cointegrated VAR • NK and OK -- fit is close BUT NK must assume NR is a random walk

  30. Conclusion • In the old-Keynesian model the economy drifts like a boat on the ocean • An interest rate policy rule, like the Taylor rule, pushes the boat in one direction or another. • Open question • Is it better to target the level of the pricing kernel rather than its rate of change?

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