A monetary Minsky model of the Great Moderation and the Great Recession
Research highlights
► Explicitly monetary model of Minsky's Financial Instability Hypothesis. ► Reproduces stylized facts of Great Moderation and Great Recession. ► Showcases new tabular method for developing dynamic models of financial flows.
Introduction
The financial and economic crisis that began in 2007 brought to an abrupt end a period of economic tranquility that many macroeconomists had celebrated as “The Great Moderation” (Benati and Surico, 2009, Bernanke, 2004, Davis and Kahn, 2008, Gali and Gambetti, 2009). The trend for recessions to become less frequent and milder abruptly gave way to a sharp decline in output, a doubling of unemployment, and a temporary fall into deflation (see Fig. 1).
The causes of this economic calamity will be debated for decades, but there should be little debate with the proposition that it was not predicted by any variant of mainstream economic analysis available at the time. It was however a prediction of the non-mainstream “Financial Instability Hypothesis” (FIH) developed by Hyman Minsky.
Steve Keen's 1995 model of this hypothesis generated qualitative characteristics that matched the real macroeconomic and income-distributional outcomes of the preceding and subsequent fifteen years: a period of economic volatility followed by a period of moderation, leading to a rise of instability once more and a serious economic crisis; and the wage share of income declining while non-financial business incomes stabilised and financial sector earnings rose (Keen, 1995, Keen, 2000, p. 93). This model is acknowledged as the reason why Keen was one of the handful of economists to anticipate and warn of the approaching economic and financial crisis well before it actually occurred (Keen, 2007, Bezemer, 2009, Bezemer, 2010, Fullbrook, 2010).
This paper extends that model to build a strictly monetary macroeconomic model of the FIH, which can generate the monetary as well as the real qualitative characteristics of both “The Great Recession” and “The Great Moderation” that preceded it. I begin with an overview of Minsky's Financial Instability Hypothesis, since many economists are unfamiliar with this non-neoclassical integrated theory of macroeconomics and finance.1
The language and concepts in Minsky's theory were also developed completely outside the mainstream economic debate of the past 30 years,2 and will therefore appear very foreign to most macroeconomists today. I hope that readers can look past this unfamiliarity to apply the spirit of Friedman's methodological dictum, that what matters is not the assumptions of a theory, but its capacity to give accurate predictions (Friedman, 1953).
Section snippets
The financial instability hypothesis—genesis
Minsky's motivation for developing the Financial Instability Hypothesis was that, since the Great Depression had occurred, a valid economic theory had to be able to generate such an outcome as one of its possible states:
Can “It”—a Great Depression—happen again? And if “It” can happen, why didn’t “It” occur in the years since World War II? These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years. To answer these questions
The financial instability hypothesis—a précis
Minsky's analysis of a financial cycle begins at a time when the economy is doing well (the rate of economic growth equals or exceeds that needed to reduce unemployment), but firms are conservative in their portfolio management (debt to equity ratios are low and profit to interest cover is high), and this conservatism is shared by banks, who are only willing to fund cash-flow shortfalls or low-risk investments. The cause of this high and universally practised risk aversion is the memory of a
Modeling Minsky I: the Goodwin model
Minsky's own attempts to devise a mathematical model of his hypothesis were unsuccessful,4 arguably because the foundation he used—the multiplier-accelerator model—was itself flawed (Keen, 2000, pp. 84–89). Keen (1995) instead used Goodwin's growth cycle model (Goodwin, 1967), which generates a
Modeling Minsky II: nonlinear functions and debt
An essential first step in modeling Minsky's insights concerning the role of debt finance was to replace the unrealistic linear function for investment with a more realistic nonlinear relation, so that when the desire to invest exceeds retained earnings, firms will borrow to finance investment. An exponential function for the propensity to invest captures the most fundamental of Keynes's insights about the behavior of agents under uncertainty: that they behave as if:
the present is a much more
Endogenous money
Though debt was modeled in the preceding system, money was not explicitly considered, and therefore price dynamics were absent. To consider these, the model had to be extended to include an explicit monetary sector. The first step here was to develop a model of an established empirical datum, that credit money is created independently of base money.
The pioneering work on this was done by (Moore, 1979, Moore, 1983, Moore, 1988). Contrary to the standard ‘money multiplier’ model of credit money
Modeling Minsky III: endogenous money
There are 5 accounts in the basic model6:
- 1.
A Bank Vault (BV) representing the banking sector's
Conclusion
The results of this model are more extreme than our actual economic situation, partly because aspects of Minsky's hypothesis have been omitted for simplicity (such as the proposition that the price level for capital goods is set in a different manner to that for ordinary commodities; Minsky, 1982a, Minsky, 1982b, p. 79), partly because aspects of reality have been omitted for the same reason (such as interest rates varying with the rate of inflation), and partly because the impact of government
Acknowledgments
This work emanated from a collaborative research effort between the United Nations Environment Program (UNEP) and CSIRO Sustainable Ecosystems to establish a regional report on Resource Efficiency: Economics and Outlook for Asia-Pacific.
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