1 A Student’s Guide to the Current Economic Crisis Dave Colander Middlebury College

2 Outline of Talk Provide a bit of history of macroeconomics Discuss how the AS/AD model can be used to explain the current crisis Discuss why the crisis is scary and the government’s attempt to get us out of the crisis.

3 The Macro Economy as a complex system

4 Some Macro History Macroeconomics as a course developed in the 1930s Before then, the was Classical economics, and quantity theory of money Macroeconomics became associated with Keynesian economics and a specific limited interpretation of Keynesian economics Keynesian economic theory was soon sidetracked into simple equilibrium models that didn’t capture possible dynamic instability.

5 Explaining the current crisis in words Structural economy changed in 1990s—inflation ended due to global competition Government expanded money supply; private sector expanded leverage. Bubbles in asset markets were created by leverage and expectations. Not noticed because there was no goods market inflation Nominal wealth increased more than real wealth could. People had irrational exuberance and expectations.

6 Causes of the Current Crisis Too Easy Monetary Policy Too Easy regulation Too strong reliance on models and past history

7 Explaining the Current Crisis in the AS/AD Model The Use and Abuse of the AS/AD model The one thing at a time approach What’s being held constant? Standard Story is an equilibrium story What’s missing? Dynamic disequilibrium problems

8 The Dynamic Disequilibrium Story: When Other Things Don’t Remain Constant

9 Explaining the Current crisis in a Picture A 450 pound 5 ft 10 inch man has a heart attack.

10 Explaining the Current Crisis in the Quantity Theory MV = PY Global competition changed the connection; asset price bubble Failure to distinguish between real wealth and nominal wealth Money no longer the relevant issue— the quantity theory of credit.

11 Government Response to the Crisis Triage Policy Treatment Policy Rehabilitation

12 Triage Policy Why is the financial sector different. It is the economic equivalent to the heart. If the financial sector stops beating, the economy stops. The Troubled Asset Rescue Package (TARP)—the 700 billion triage policy. Keep the financial sector going.

13 Treatment policy Monetary policy Liquidity trap Quantitative easing Fiscal policy Fiscal stimulus Automatic stabilizers Expectations policy

14 Rehabilitation Stage Repairing the Damage Done in the Triage and Treatment Stage Eliminating the Deficit Creating a sense of fairness Countering the sense of unfairness from the bailout programs. Too big to fail and the moral hazard problem The Problem waiting in the Wings: International Financial Crisis Trade deficit Dollar overhang

15 Three Ideas to Keep in Mind in Structuring new Regulation The golden rule of economics: Him who has the money makes the rules. If you will bail out, you have to regulate; avoid the moral hazard problem Law of Diminishing Regulation: Technological change and leaning by sneaking around undermines regulation