The Theoretical Framework That Underpins the Origins of the ‘Great Recession’

Abstract

This chapter examines the relevance of the New Consensus Macroeconomics (NCM), or Neo-Wicksellian, model from a policy perspective in the light of the ‘great recession’. It is argued that a monetary policy rule based on inflation, and perhaps also on growth, such as that pursued by the major central banks, would be insufficient to prevent or even detect a crisis such as the ‘great recession’. This drawback is due not only to the limited nature of the policy makers’ objective function, but also to the structure of the NCM paradigm. In particular, the NCM models suffer from a number of deficiencies. First, there is an internal inconsistency in that the policy implications advocated by NCM-style models are assumed rather than being derived explicitly from such models. The propositions that inflation is under the direct control of the central bank, while output and unemployment in the long run are not, are imposed on the model rather than being demonstrated theoretically in a convincing manner. Second, the NCM models are based on the transversality assumption, which leads to the conclusion that commercial banks do not exist in the model, nor monetary aggregates or liquidity preference. Interestingly enough, the absence of monetary aggregates may be at the root of the current woes. Third, financial innovation in the last ten years or so has rendered traditional monetary aggregates obsolete as measures of overall liquidity.