8. A comprehensive business cycle model* ) isolated state („Viking village“) => Thünen paradigm Corn = consumption and investment => Ricardo paradigm 1U. van Suntum, Lecture KuB Improved version of the model in CAWM Discussion Paper No 24 (2009): Economic Confidence, Neagtive Interest Rates, and Liquidity: Towards Keynesianism 2.0 (Ulrich van Suntum)Economic Confidence, Neagtive Interest Rates, and Liquidity: Towards Keynesianism 2.0 U van Suntum, Lecture KuB 1

Stylized facts of the recent crisis (I): banks hoard money at central bank (Source: council of economic advisors JG 2008) © Ulrich van Suntum © U.van Suntum, CAWM 2U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 2

© U.van Suntum, CAWM Stylized facts of the recent crisis (II): sharp decline in money growth rates (Source: spring report on business cycle 2009) 3U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 3

© U.van Suntum, CAWM Stylized facts of the recent crisis (III): high capital-market interest rate (Source: spring report on business cycle 2009) 4U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 4

Shortcomings of conventional textbook Keynesianism only one single interest rate Financial sector is not explicitly incorporated Psychological elements widely missing Missing link between savings and capital stock 5U. van Suntum, Lecture KuB U van Suntum, Vorlesung KuB 5

The Viking Village model: Five non-standard features 1. production function with degree of homogeneity less than 1 2. savings S derived from a (reduced) wealth optimization approach 3.credit money with private banking system 4. money market interest rate distinguished from capital market interest rate 5. confidence q an explicit (and endogenous) variable in the model 6U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 6

Assumptions in more detail seed is the only commodity depreciation rate = 1 => (gross) saving S = capital stock K Paper money M for transaction and liquidity reserves Three kinds of wealth: real capital K, currency L, deposits D stationary economy (no technical progress) population = labor force N (perfectly elastic) real wage rate is fixed exogenously 7U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 7

The model at a glance Firms Private Households Private Banks Central Bank Government Capital Market 8U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 8

The supply side sublinear production function Pure profits > 0 Labor demand of farms Capital (seed) demand of farms 9U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 9

The demand side: household behavior,. q = confidence, i = capital market interest rate, i M = money market interest rate total wealth liquidity real capital 10U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 10

Capital market equilibrium Demand of real capital Supply of real capital Generally, the equlibrium interest rate i must be calculated numerically With neatly chosen parameters, an analytical solution can be derived (see below) 11U. van Suntum, Lecture KuB Additional capital supply from central bank Additional capital demand from government U van Suntum, Lecture KuB 11

Monetary Equlibrium and Nominal Income Money supply:Money demand: 12U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 12

Equilibrium interest rate With H being complex, but exogenous auxiliary variable 13U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 13

Dynamic simulations Adaptive expectations for both the price level p and total icome Y labor input depends on expectation of Y for period t capital input depends on expectation of Y for period t+1 14U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 14

Results at a glance 15U. van Suntum, Lecture KuB..\..\..\work in progress und sonstige Desktop-Dateien\confidence model VI.xlsx U van Suntum, Lecture KuB 15

Results: short term decline in economic confidence q: roughly equal to long term results increase in public deficit spending g: real income increases because of rising consumption and rising expected income increase in fiat money : real income increases because of real balance effect increasing central bank credits K m : real income increases because of increase in capital supply and real balance effect decreasing money market interest rate i m : like increasing K M rise in real wage rate: real income and employment decrease tax rate cut: real income decreases because of Haavelmo-effect (increase in liquidity demand) 16U. van Suntum, Lecture KuB..\..\..\work in progress und sonstige Desktop-Dateien\confidence model VI.xlsx U van Suntum, Lecture KuB 16

Results : long term decline in economic confidence q: real income decreases due to increasing preference for liquidity and decreasing supply of real capital increase in public deficit spending g: real income decreases because of crowding out effect and decreasing government consumption increase in fiat money : real income unchanged, price level increases increasing central bank credits K m : real income increases because of increase in capital supply, price level eventually increases decreasing money market interest rate i m : like increasing K m rise in real wage rate: real income and employment decrease tax rate cut: real income increases because of increased savings 17U. van Suntum, Lecture KuB..\..\..\work in progress und sonstige Desktop-Dateien\confidence model VI.xlsx U van Suntum, Lecture KuB 17

Some General Conclusions Keynesian results in the short term, monetaristic results in the long term model fits stylized facts during the recession quite well long run effect of monetary policy on real income depends on how it is done short run effects of monetary policy are limited by zero lower bound on interest rates direct central bank credits to firms could help the latter are only inflationary, however, if they increase the amount of public debt 18U. van Suntum, Lecture KuB U van Suntum, Lecture KuB 18