The Goals of his Research To undersand financial crises wih a model of muliple seady sae equilibria To undersand he role of fiscal policy in resoring

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1 Fiscal Policy Can Reduce Unemploymen: Bu There is a Beer Alernaive Federal Reserve Bank of Alana January 9 h 2010 Roger E. A. Farmer Deparmen of Economics UCLA 1

2 The Goals of his Research To undersand financial crises wih a model of muliple seady sae equilibria To undersand he role of fiscal policy in resoring full employmen 2

3 The Conclusions In response o a sock marke crash of 20% unemploymen is prediced o increase by 20% A balanced budge fiscal policy can resore full employmen bu labor income axes would increase by 54% o 93% The muliplier is beween 0.33 and

4 A Beer Policy Direc inervenion o suppor he value of he sock marke Preven boh bubbles and crashes by sock marke purchases financed wih agency deb 4

5 Connecion wih New- Keynesian Theory New Keynesian economics assumes sicky yp prices. Deviaions from he naural rae of unemploymen are emporary. Old Keynesian economics assumes flexible prices. There is a coninuum of seady sae unemploymen raes indexed by beliefs. 5

6 Connecion wih Search Theory Two kinds of mulipliciy in search models Finie mulipliciies: Diamond 1982,1984 Seady sae Coninuum: Howi and McAfee 1987 Coninuum follows from bilaeral monopoly 6

7 Comparing 2008 wih he Grea Depression inde ex number percen of lab bor force (inverse scale e) inde ex number percen of lab bor force (inverse scale e) Real Value of he S&P 500 Unemploymen Rae Real Value of he S&P 500 Unemploymen Rae The Grea Depression The 2008 Financial Crisis 7

8 The War-Time Recovery Doesn Fi he Paern in ndex number pe ercen of labor force (in nverse scale) Real Value of he S&P 500 Unemploymen Rae 28 The Sock Marke and Unemploymen During WWII 8

9 Governmen Expendiure Was Imporan 7 0 index number perc cen of labor fo orce (inve erse scale) Real Governmen Purchases Unemploymen Rae 24 Governmen Purchases and Unemploymen During WWII 9

10 Srucure of Talk I will explain he mulipliciy in a represenaive agen version of he model I will explain how he model is alered o allow for overlapping generaions I will presen he resuls of a compuaional experimen 10

11 Main Idea Two Ideas in Keynes 1. Labor marke is no a spo marke 2. Animal Spiris This paper builds hese wo ideas ino a micro-founded general equilibrium model 11

12 The Marke Failure Labor marke is a search marke wihou he Nash Bargain Cosly Search and Recruiing Exernaliy suppors differen allocaions as equilibria Animal spiris i selec an equilibrium i 12

13 A Model 1 Lucas ree non reproducible 1 good produced by labor and capial No disuiliy of work everyone wans ajob Everyone fired and rehired every period No uncerainy 1/13/

14 The Labor Marke Finding a job uses resources Two echnologies Producion echnology Maching echnology 1/13/

15 Terminology Z z K H Money value of GDP Physical goods produced Number of rees (Normalized o 1) Time endowmen of household (Normalized o 1) 1/13/

16 Terminology C Money value of consumpion G Money value of governmen purchases 1/13/

17 Terminology w Money wage r pk p Q s Money renal rae Relaive price of a ree Money price of a commodiy Dae value of a dollar delivered a dae s 1/13/

18 Terminology L X Employmen Producion workers V Recruiers L= X + V 1/13/

19 Technologies z = K 1 α X α Producion echnology 1/2 1/2 L = H V Mach echnology H 1 K 1 1/13/

20 Planning Problem z ( ) z = L 1 L α L* U* X* V* L* 1 1/13/ L

21 Decenralizaion Agens ake wages and prices as given Households ake hiring probabiliy as given Firms ake hiring effeciveness as given All markes clear 1/13/

22 More Terminology q% Probabiliy of a worker being hired q One recruier hires his many workers L = qh % L = qv 1/13/

23 Firm s Problem max pz wl rk L = qv L = X + V z K α X 1 α 1/13/

24 Firm s Problem 1 α 1 max pk α L 1 wl rk q Firm acs like a firm in an aucion α Z = rk marke bu akes q as given ( α ) 1 Z = w L q is an exernaliy ha represens marke ighness. For any given q here is a zero profi equilibrium 1/13/

25 Normalizaion w = 1 Z = 1 1 α L 1/13/

26 Comparison wih he Classical Model Classical Old Keynesian ( 1 α ) Z = wl ( α ) L = 1 w = 1 1 Z = wl w 1 α Z ( ) = L= ( 1 α) L Z 26

27 Household s s Problem max u = =00 β log ( c ) ( ) p K pc p r K wq%, + 1 +, + + k k 1/13/

28 Soluion H = h 1 = Q s wl s = ( 1 β ), C = p K + h k 1/13/

29 No Arbirage Implies ( ) = k, k, p Q p αc Q + 1 = βc C + 1 pk, = C βα β 1 β 1/13/

30 Proposiion There is a bound b such ha for every bounded sequence of asse prices here is an equilibrium where 1/13/

31 Equilibrium (No Governmen) 1 β Z = C = p βα k, z = c = L 1 1 q 1 α C C L = p = % 1 α c q = L U = 1 L q 1 L = V 2 = L 1/13/

32 Wha Deermines Z? Z is aggregae demand Consruc an infinie horizon model wih a Blanchard-Weil populaion srucure. Explore he role of fiscal policy. 32

33 Household s s Problem max u = =0= 0 log c ( βπ ) ( ) ( ) p K pc p k, 1 k, r K wq 1 τ % ( 1 ) 1/13/

34 Definiion β%β = % α = 1 π 1 βπ ( ) π 1 βπ 1 π ( )( ) 1 π 1 βπ ( ) 34

35 The Model 1 C = C + α% Z + p + B τ α Z % ( ( 1 ) ) + 1 k, R β R = p + αz k, p k, 35

36 The Model Coninued Z = C + G L ( 1 ) = α Z τ 1 RB B = G ( 1 α ) Z R 36

37 Seady Sae B Z = H( R) pk + + G Marke R Equilibrium R = 1 + αz p k No Arbirage 1 ( R 1) B τ = + G ( 1 α ) Z R 37

38 AMarkeCrash R NA B A ME Z 38

39 Fiscal Policy R B C A NA ME Z 39

40 Disc. Facor Life Expec ancy Simul us % GDP Tax incr. % Wage Inc Cons Drop % GDP Mulipl ier Op In. Rae % per yr. β= β= β= β= New In. Rae β= β= β= β= Effecs of a Fiscal Simulus 40

41 Welfare Cos Loss of confidence causes 20% drop in seady sae consumpion Resoring full employmen reduces consumpion by a furher 41% of full employmen GDP Welfare unambiguously falls 41

42 Welfare Cos if G yields Uiliy Assume Cobb Douglas Uiliy and C and G have equal weighs Confidence drop of 20% reduces seady sae consumpion by 20% Resoring full employmen wih he wrong balance of G and C leads o a furher 17% drop of uiliy in unis of seady sae consumpion 42

43 Is here a Beer Policy? R Sock marke suppor B C A NA ME Z 43

44 Summary Unemploymen depends on self- fulfilling beliefs The Grea Depression and he 2008 Financial Crisis were caused by self- fulfilling drops in confidence Fiscal policy may no be he bes soluion 1/13/