i PROSPERITY FOR ALL ii   iii PROSPERITY FOR ALL HOW TO PREVENT FINANCIAL CRISES ROGER E. A. FARMER iv Oxford University Press is a department of the University of Oxford It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide Oxford is a registered trade mark of Oxford University Press in the UK and certain other countries Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America © Oxford University Press 2017 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Library of Congress Cataloging-in-Publication Data Names: Farmer, Roger E A., author Title: Prosperity for all : how to prevent financial crises / Roger E.A Farmer Description: New York : Oxford University Press, 2016 | Includes bibliographical references and index Identifiers: LCCN 2016008326 (print) | LCCN 2016018865 (ebook) | ISBN 9780190621438 (hardback) | ISBN 9780190621445 () | ISBN 9780190621452 () | Subjects: LCSH: Economic policy | Monetary policy. | BISAC: BUSINESS & ECONOMICS / Economics / General | BUSINESS & ECONOMICS / Economic Conditions | BUSINESS & ECONOMICS / Economics / Macroeconomics Classification: LCC HD87.5 F37 2016 (print) | LCC HD87.5 (ebook) | DDC 330.15/6—dc23 LC record available at https://lccn.loc.gov/2016008326 1 3 5 7 9 8 6 4 2 Printed by Sheridan Books, Inc., United States of America   v This book is dedicated to my son, Leland Edward Farmer There is so much to learn, for men, That I dare not go to bed again The swift, the swallow, the hawk, and the hern There are millions of things for me to learn From “The Child in the Orchard,” by Edward Thomas (1979, p 149) vi   vii CONTENTS PREFACE  ACKNOWLEDGMENTS  IX XIII Prosperity for All  Keynes Betrayed  23 The Demise of the Natural Rate Hypothesis  31 Let’s Stop Pretending Unemployment Is Voluntary  47 Five Problems with New Keynesian Economics  58 Why Unemployment Persists: The Keynesian Search Model Explained  73 Wall Street and Main Street  90 viii viii  Contents The New Keynesian Model Explained  109 The Farmer Monetary Model Explained  131 10 Keynesian Economics without the Consumption Function  154 11 How to Prevent Financial Crises  182 NOTES  REFERENCES  INDEX OF NAMES INDEX OF SUBJECTS 209 243 263 269   ix PREFACE This book arose from a series of three lectures that I gave in 2013 while I was a visiting Senior Houblon-​Norman Fellow at the Bank of England I have since updated the lectures and expanded them with material developed from my published research, from a series of undergraduate lectures that I gave at the University of California Los Angeles in 2014 and 2015, a number of Op Ed pieces, and from material that has appeared on my blog, Roger Farmer’s Economic Window This volume is written for anyone with an interest in how to prevent financial crises and achieve prosperity for all I endeavored to make my ideas accessible to anyone with a basic knowledge of economics, and I hope my book appeals to students, practitioners of economics, policymakers, and the general public During the process of seeking a publisher for the manuscript, I received feedback from several reviewers I do not know their identities, but it seems clear from the content of the reviews that some of my reviewers were academic economists with PhDs, some were journalists or bloggers, and some were practitioners of economics in business or government The feedback I  received revealed a great deal about the economics discipline The reviews were laudatory and enthusiastic about my original ideas and contributions, and the readability of the manuscript But, there was a disconnect between academic economists   263 INDEX OF NAMES Abel, Andrew B., 220n15 Admati, Anat, 242n33 Akerlof, George, 68, 221n26, 224n10, 228n27 Alchian, Armen A., 213n29 Alesina, Alberto, 172 Ando, Albert, 14, 83, 165, 212n23, 224n12, 237n10 Andolfatto, David, 222n3 Angeletos, George-Marios, 215n19, 235n4 Arrow, Kenneth J., 139, 233n15 Azariadis, Costas, 26–28, 214n8, 214n13, 234n1, 235n4 Backus, David K., 92, 226n7 Bagehot, Walter, 182, 239n1 Balke, Nathan S., 210n7 Barbon, Nicholas, 94, 226n10 Barro, Robert J., 64, 93, 172, 213n27, 220n17, 226n8 Bean, Sir Charles, 13 Becker, Gary, 172 Benhabib, Jess, 28, 214n15, 215n19, 235n4 Bentham, Jeremy, 3, 209n3 Berentsen, Aleksander, 216n19 Bernanke, Ben, 7, 13, 131, 146, 210n8, 210n11, 232n1, 240n8 Beveridge, William, 78 Beyer, Andreas, 43, 116–118, 216n17, 230n10–13 Biden, Joe, 172 Blanchard, Oliver, 14, 173, 234n18, 238n20 Blinder, Alan, 215n19 Borio, Claudio, 134, 213n30, 232n5 Box, George, 49 Brown, Amy S., 215n19 Buiter, Willem, 199, 202, 239n2, 239n4, 241n26, 242n30 Burgen, Stephen, 211n15 Caballero, Ricardo J., 221n25 Calvo, Guillermo A., 62, 115, 219nn10–11, 230n8 Carnegie, Andrew, 5 Carney, Mark, 197 Cass, David, 26–28, 91, 95, 214n8, 225n3, 226n12, 234n1, 235n4 Cherrier, Beatrice, 214n7, 214n12, 214n17 Christiano, Lawrence J., 217n8, 219n12 Churchill, Winston, 165 Cochrane, John, 172, 225n5, 226n5, 227n17, 231n17 Coibion, Olivier, 220n15 264 264  Index of Names Constantinides, George M., 220n15 Copernicus, Nicolaus, 70 Corpe, Keith, 212n25 Coyle, Diane, 229n2 Cramton, Peter, 222n38 Dai, Lu, 241n21 Davidson, Paul, 29, 71, 222n37 Davis, Stephen J., 222n2 Debreu, Gerard, 139, 233n15 Del Negro, Marco, 134, 232n6 DeLong, Bradford J., 68, 70, 212n22, 221n27, 222n34 De Vroey, Michel, 213n4, 214n18 Diamond, Peter, 76, 222n3 DiCecio, Riccardo, 218n11 Dicks-Mireaux, Leslie, 78, 223n6 Dow, Christopher, 78, 223n6 Drehmann, Mathias, 213n30 Edgeworth, Francis Y., 68–69, 221n29 Eichenbaum, Martin, 217n8, 219n12 Einstein, Albert 32, 216n8 Engemann, Kristie M., 218n11 Epstein, Larry, 226n7 Evans, Charles L., 217n8, 219n12 Evans, George, 233n12 Ewing, Bradley, 230n13, 231n17 Fama, Eugene F., 90, 172, 225n1 Farmer, Roger E. A., 117, 153, 211nn17–18, 212n25, 213n31, 213n2, 214n7, 214n14, 214n15–16, 214n18, 215nn19–20, 216nn17–18, 218nn9–10, 219n8, 219n11, 220n20, 221nn24–25, 223n7, 224n11, 225n16, 225n2, 227nn14–15, 228nn20–22, 228n27, 230n6, 230nn10–13, 231n18, 232nn8–9, 233nn10–12, 234nn18–19, 234n22, 235nn2–5, 237n9, 238n17, 238n24, 238n26, 239nn27–28, 239n4, 240nn9–14, 240n16, 240n19, 241n27, 242n32 Fischer, Stanley, 13, 64, 220n17 Fisher, Irving, 96, 148, 227n16, 234n23 Fitoussi, Jean-Paul, 211n18 Flemming, John 188 Ford, Henry, 5 Friedman, Milton, 7, 14, 16, 38–42, 45, 58, 67, 83, 86, 137, 146, 165, 183–184, 201, 205, 210n12, 212n23, 212n26, 216nn10–12, 216n14, 218n2, 223n8, 224n12, 225n17, 233n10, 234n21, 237n10, 239n3, 240n6 Frisch, Ragnar, 23–24, 28, 49, 119, 141, 155, 213n1 Fritsche, Ulrich, 212n25 Frydman, Roman, 133, 224n14, 232n3 Fuhrer, Jeffrey C., 64, 70, 220n16, 222n35 Gagnon, Joseph E., 239n5 Galí, Jordi, 66, 217n8, 221n22, 229n1 Gates, Bill, 196 Geanakoplos, John, 232n8 Gelain, Paolo, 215n19 Gertler, Mark, 65–66, 70, 217n8, 220n19, 221n22, 222n36, 229n1 Giannoni, Marc, 135, 232n6 Goldberg, Michael D., 224n14 Goodhart, Charles A. E., 241n21 Gordon, Robert J., 143, 210n7, 231n18, 234n20 Gorodnichencko, Yuriy, 220n15 Gorton, Gary, 242n33 Grandmont, Jean Michel, 234n1   265 Index of Names  265 Granger, Clive W., 103–104, 107, 118, 228n25, 230n15 Gray, Jo-Anna, 216n13 Greenberg, Maurice R., 241n23 Greenwood, Jeremy, 231n20 Guerrazzi, Marco, 215n19 Guesnerie, Roger, 234n1 Guner, Nezih, 232n20 Guo, Jang-Ting, 28, 214n15, 228n27, 235n4 Haldane, Andy G., 229n4 Hall, Robert E., 220n19, 224n13 Haltiwanger, John C., 222n2 Hamilton, James D., 228n24, 239n5 Hamley, James, 238n23 Hansen, Alvin, 13, 133, 170, 179, 181, 212n21, 232n4 Hansen, Lars P., 90, 225n1 Harberger, Arnold C., 67, 221n23 Hawtrey, Ralph, 237n11 Hayek, Friedrich A., 5–8, 209n5, 210nn13–14 Heathcote, Jonathan, 215n19 Heisz, Andrew, 98, 226n11, 227n18 Hellwig, Martin, 242n33 Henry, Jérôme, 230n10 Hicks, Sir John, 13, 24–25, 133, 170, 179, 181, 212n21, 213nn3–4, 232n4 Hodrick, Robert J., 50, 217n5, 218n9, 237n9 Hollenhorst, Andrew, 235n3 Honkapohja, Seppo, 233n12 Hoover, Kevin D., 212n21, 218n1 Hosios, Arthur J., 222n4 Howitt, Peter, 224n13 Hume, David, 59, 132, 218n7, 232n2 Hurwicz, Leonid, 209n4 Jestaz, David, 211n18 Jevons, Stanley W., 26, 214n9, 225n3 Jobs, Steve, 5 Johnson, Simon, 242n33 Jordan, Michael, 46 Kahn, Richard, 14, 212n24 Kashiwagi, Masanori, 215n19 Kehoe, Timothy, 233n16 Keynes, John Maynard, x-xi, 6, 13–14, 20, 22–32, 35, 47, 59–60, 67, 71–72, 83–84, 86, 98–99, 144, 158–160, 181–182, 209n6, 217n2, 217n4 Khramov, Vadim, 235n4 Kimball, Miles, 191, 240n15, 242n30 King, Robert G., 216n17 Kiyotaki, Nobuhiro, 232n8 Klein, Benjamin, 213n29 Klenow, Peter, 219n13 Kocharkov, Georgi, 231n20 Kocherlakota, Narayana, 211n17, 215n19 Koenig, Evan, 241n28 Koo, Richard, 135, 232n7 Kotlikoff, Larry, 242n33 Kreps, David, 226n7 Krishnamurthy, Arvind, 221n25 Krugman, Paul, 13, 168, 181, 212n20, 212n22, 219n11, 237n14 Kuhn, Thomas, 58–59, 70, 218n4, 221n33 Kwak, James, 242n33 Kydland, Finn E., 28, 48, 214n15, 217n4 Lakatos, Imre, 20, 58–59, 70, 215n6, 218n6, 221n32 Lansing, Kevin J., 221n25 Laubach, Thomas, 210n8 La’O, Jennifer, 215n19, 235n4 Leijonhufvud, Axel, 32, 58, 218n5, 235n3 LeRoy, Stephen, 92, 95, 225n5 266 266  Index of Names Levenson, Thomas, 35, 216n8 Levine, David K., 233n16 Lincoln, Abraham 42 Lipsey, Richard G., 216n7 Litterick, David, 240n18 Long, Charles, 48 Long, John B., 217n4 López-Salido, David J., 66, 221n22 Lucas Jr., Robert, 27, 42, 47, 52, 64–66, 72, 85, 139, 154, 173, 216n15, 217n3, 220n18, 221n21, 224n15, 225n16, 233n14 MacKay, Charles, 221n25 Magill, Michael, 226n9 Malinvaud, Edmond, 27 Malin, Benjamin, 219n13 Mankiw, Gregory N., 51, 172–173, 217n7, 219n13, 238nn18–19 Marcellino, Massimiliano, 230n10 Martin, Alberto, 221n25 Maskin, Eric, 209n4 McAfee, Preston, 224n13 McAndrews, James J., 239n2 Mehra, Raj, 92, 226n6 Menzio, Guido, 216n19 Merz, Monica, 222n3 Miao, Jianjun, 215n19 Michaillat, Pascal, 215n19 Milgrom, Paul R., 220n19 Minsky, Hyman, 29 Mishkin, Frederic S., 210n8 Modigliani, Franco, 14, 51, 83, 165, 212n23, 217n6, 224n12, 237n10 Morgenstern, Oskar, 226n7 Moore, George, 64, 70, 220n16, 222n35 Moore, John, 232n8 Mortensen, Dale, 76, 222n3 Murphy, Kevin, 173 Musgrave, Alan, 218n6 Muth, John, 42, 216n16 Myerson, Roger, 209n4 Nelson, Charles, 125, 231n17, 231n19 Neuer, Manuel, 46 Newton, Isaac, 35 Nickell, Stephen, 222n1 Nicoló, Giovanni, 235n4 Nixon, Richard, 37 Nourry, Carine, 225n2, 227n14 Obama, Barak, 110n7 Okun, Arthur, 110, 221n23, 229n3 Oreopoulos, Philip, 98, 226n11, 227n18 Osborne, George, 240n7 Owyang, Michael T., 218n11, 238n23 Pareto, Vilfredo, 91 Paul, Ron, 6–7, 210n9 Pearce, Kerry A., 212n21, 218n1 Peden, George C., 237n13 Perotti, Roberto, 238n20 Perri, Fabrizio, 215n19 Phelps, Edmund S., 38–40, 45, 67, 132, 211n18, 216n11, 232n3, 238n25, 241n22 Phillips, William A., 33, 35, 37, 215n4 Pierdzioch, Christian, 212n25 Pigou, Arthur, 28, 32, 51, 215n3, 217n8 Pissarides, Christopher, 76, 222n3 Platonov, Konstantin, 181, 239n28 Plosser, Charles, 48, 125, 217n4, 231n17, 231n19 Plotnikov, Dmitry, 175, 215n19, 220n20, 232n9, 234n18, 238n24, 239nn27–28 Popper, Karl, 58–59, 70, 218n3 Porter, Robert, 92, 95, 225n5 Porteus, Evan, 226n7 Posen, Adam S., 210n8   267 Index of Names  267 Prescott, Edward C., 28, 48–50, 52, 92, 200, 214n15, 217nn4–5, 218n9, 226n6, 237n9 Quinzii, Martine, 226n9 Ramey, Valerie, 174–175, 238nn22–23 Ramsey, Frank P., 48, 217n4 Rapping, Leonard, 47–48, 64, 217n3, 220n18 Raskin, Matthew, 239n5 Rawls, John, 226n13 Reinhart, Carmen M., 228n19 Reis, Ricardo, 219n13 Remache, Julie, 239n5 Rietz, Thomas, 93, 226n8 Robinson, Joan, 26, 29, 214n6 Rogoff, Kenneth S., 13, 228n19 Romer, Christina, 174–175, 209n7, 238n21 Romer, David, 51, 174–175, 217n7, 238n19, 238n21 Roosevelt, Franklin Delano, 161 Rotemberg, Julio J., 62–63, 219n9 Roth, Alvin, 222n38 Routledge, Bryan R., 92, 226n7 Sack, Brian P., 239n5 Saez, Emmanuel, 215n19 Saïdi, Aurélian, 214n7, 214n12, 214n17 Sala, Luca, 65, 220n19 Samuelson, Paul, 13, 25–26, 34–38, 44–45, 51, 58–59, 66, 108, 201, 212n21, 213n5, 215n5, 216n9, 218n1 Santos, Cezar, 231n20 Sargent, Thomas, 173 Say, Jean-Baptiste, 31–32, 215n2, 237n13 Scarth, William, 216n7 Schmitt-Grohé, Stephanie, 215n19 Schorfheide, Frank, 135, 232n6 Schuh, Scott, 222n2 Schwartz, Anna J., 7, 210n12, 239n3 Sen, Amartya, 68–69, 229nn29–31 Shapley, Lloyd, 222n38 Shell, Karl, 26–28, 91, 95, 213n27, 214n8, 214nn10–11, 225n3, 226n12, 234n1, 235n4 Shiller, Robert J., 68–69, 90–92, 95, 97, 200–201, 211n16, 221n16, 221n26, 221n28, 225n1, 225n5, 228n27, 242n29 Shimer, Robert, 224n13 Shleifer,Andrei, 221n27, 222n34 Sims, Christopher A., 210n10, 219n13, 219n14 Smets, Frank, 217n8 Smith, Adam, 31, 215n1 Solow, Robert M., 13, 36–38, 45, 215n19, 216n9 Soros, George, 192, 196 Stephey, M. J., 241n25 Stiglitz, Joseph, 13 Summers, Lawrence, 181, 191, 212n22, 221n27, 222n34, 234n18, 240n17 Sumner, Scott, 199–202, 241n26 Taleb, Nassim, 112, 229n5 Taylor, John B., 114, 131, 230n7, 232n1 Tobin, James, 67 Trigari, Antonella, 65, 70, 220n19, 222n36 Tsatsaronis, Kostas, 213n30 Uhlig, Harald, 173 Uribe, Martín, 215n19 Valles, Javier, 221n22 Venditti, Alain, 225n2, 227n14 Ventura, Jaume, 221n25 Volcker, Paul, 102, 183 Von Neumann John, 226n7 Von Wachter, Till, 98, 226n11, 227n18 268 268  Index of Names Waldmann, Robert J., 221n27, 222n34 Walras, Léon, 24, 61 Wang, Pengfei, 215n19, 235n4 Watson, Mark, 216n17 Wen, Yi, 215n19, 235n4 Wheeler, Christopher H., 218n11 Whitard, Damian, 241n24 Wicksell, Knut, 23, 213n1 Wiederholt, Mirko, 219n13 Woodford, Michael, 27, 200, 203–204, 214n14, 217n8, 229n1, 230n9, 234n1, 235n4, 241n26, 242n31 Wouters, Raf, 217n8 Wright, Randall, 216n19 Wunnava, Phanindra, 230n13, 231n17 Wu, Cynthia J., 239n5 Xu, Lifang, 215n19 Yun, Tak, 219n10 Zabczyk, Pawel, 242n32 Zha, Tao, 210n10 Zingales, Luigi, 173 Zin, Stanley E., 92, 226n7 Zoega, Gylfi, 211n18 Zubairy, Sarah, 238n23   269 INDEX OF SUBJECTS aggregate demand and animal spirits, 157–158, 179 and bargaining, 78 and demand-side policy, 17, 41, 74, 202 and fiscal policy, 17, 160, 166, 170, 178 and Great Depression, 25, 158–160 and interest rates, 113, 202 and Keynesian economics, 157–160, 177–178, 221n23, 235n7, 236n8 and unemployment, 25, 41, 52, 57, 83, 121, 144, 149, 170, 230n13 and wealth, 83, 170, 178, 201 shocks to, 60, 114, 121–122, 128, 133, 136, 151, 194, 231n18 aggregate supply and Keynesian economics, 156–157, 159, 177–178 and Keynesian search theory, 86, 178 and supply-side policy, 74, 174 shocks to, 60, 114–115, 124, 128, 133, 194, 231n18 animal spirits and aggregate demand, 57 and belief function, 84–85 and business cycles, 30, 67, 98, 154–155, 202 and confidence, 27, 84, 98, 106 and financial crisis 2008, 104, 107, 228n26 and Great Recession, 71, 107 and Keynesian economics, 25, 27, 67, 98 and multiple equilibria, 154 and stock market, 97, 104–107, 180, 194–195, 199 and unemployment, 21, 52, 57, 71–73, 106, 155, 195 auctioneer, 24, 61 Bank for International Settlements, 19, 20, 134 Bank of England, 13, 15, 142, 183–188, 192–194, 197–199, 203, 205 bargaining over wage, 76–78, 83, 105, 222n4 beliefs (see also Belief function; Self-fulfilling beliefs) and adaptive expectations, 137 and business cycles, 26–28, 65, 69, 179, 225n3 and Great Depression and Great Recession, 1, 107 270 270  Index of Subjects beliefs (Cont.) and multiple equilibria, 71, 86, 138, 144, 154 and rational expectations, 85, 139 and stock market, 69 and unemployment, 57, 65, 69, 71, 143–144 and wealth, 77, 83, 136, 179 fundamental, 15, 26, 65, 69, 86, 138, 144, 204 persistent, 136, 143 significance of, 27, 84, 153–154 shock to, 151, 153 belief function, 83–86, 133, 136–138, 141–142, 151–152 Beveridge curve, 78–80 BIS, see Bank for International Settlements bubble, 67, 69–70, 105–106, 135, 193, 196, 206, 221n25 calibration, 49, 51, 63, 76 Calvo Fairy, see New Keynesian economics and Calvo Fairy CAPE, see price-to-earnings ratio capital controls, 199 central bank (see also Bank of England, Federal Reserve System) and Great Moderation, 6 and inflation, 16, 38, 109, 197 and inflation targeting, 6, 16, 19 and interest rates, 114, 135, 170, 182, 194, 197, 200, 230n9, 237n15 and New Keynesian economics, 30, 33, 46, 56, 111, 205 and Phillips Curve, 35 and real economic activity, 16, 47, 109, 149, 212n26 and stock markets interventions, 18–19, 30, 105, 121, 131, 182, 199, 201, 204, 206 balance sheet of, 19, 184, 203–204 classical economics (see also neoclassical synthesis; real business cycle) and confidence, 28 and cost of recessions, 66 and demand shocks, 122 and equilibrium approach to markets, 47, 56, 75, 85 and flexibility of prices, 60–62, 74, 115 and natural rate of unemployment, 48, 124, 126 and Phillips Curve, 35–36 and policy, 13, 16, 74, 127, 173–174 and self-stabilization of economy, 23, 31, 51–52 and stock market, 12, 90, 226n5 and unemployment, 34, 47, 60, 64, 74 rebirth of, 32 competitive equilibrium, 8 confidence, 1, 26–29, 51, 84, 98, 100, 105–106, 179, 192, 206, 219n11 consumer price index, 43, 62–63, 117, 186 consumption and GDP, see consumption function and income, see consumption function and real interest rate, 113 and representative agent, 48, 66, 91, 96, 116 and stock market, 12, 100 and taxes, 175 and wealth, 14–15, 165, 175, 178, 211n18, 212n23 dynamics of, 50 consumption function, 14–15, 137, 160, 163–169, 177–178, 212n23 CPI, see consumer price index crowding out effect, 166, 170, 171   271 Index of Subjects  271 Dodd-Frank Act, 205 DSGE, see dynamic stochastic general equilibrium model dynamic stochastic general equilibrium model, 48, 84–85, 110–116, 135, 138, 140–141 efficient markets hypothesis, 21, 90, 111 Employment Act of 1946, 6, 204 endogenous business cycle, 28–29, 155, 215n19 equity premium puzzle, 92–93 ETF, see exchange-traded fund excess volatility puzzle, 92–93, 225n5 exchange-traded fund, 19, 191–201 expectations adaptive, 41–42, 137–139 rational, 42–43, 45, 48, 72, 84–86, 127, 138–139, 150 Farmer Monetary Model, 21, 112, 127, 132–145, 149–152, 230n6 (see also beliefs, belief function, Taylor Rule) Farmer Monetary IS Curve, 133, 141, 151–152 Federal Reserve System, 6–7, 102, 106, 110–112, 117, 131, 136, 139, 142, 144–146, 179, 183–191, 200, 203, 206, 211n19, 239n5 financial crisis and balance sheet recessions, 135 and confidence, 100, 107, 206, 219n11, 228n26 and fear, 179 and financial panic, 1, 100, 182, 183, 242n33 and incomplete participation, 95, 135 and market completeness, 94, 146–49 and New Keynesian economics, 70, 111, 134–135 and policy, 145, 171, 182–187, 196, 205–207, 241n21, 242n33 and rationality, 68 and unemployment, 98–99 parable of, 146–149 financial cycle, 20, 134–135, 232n8 (see also financial crisis) financial policy committee, 193–199, 205 first principle of economics, 68 first welfare theorem, 8–9, 82, 91, 94 fiscal policy (see also government expenditure; government investment expenditure; multiplier, taxes) and empirical evidence, 155, 160–162, 171–172 and government debt, 175, 177 and Keynesian economics, 6, 155, 160–162, 177, 181 and new financial policy, 195 and New Keynesian economics, 74, 181 and unemployment, 36, 219n11, 239n27 austerity, 13, 172, 175 balanced budged, 176, 177 fiscal expansion, 155, 162 forward guidance, 200, 203–204, 241n26 FPC, see financial policy committee free trade, 9, 90–91, 94, 97, 107, 206 (see also markets, free) frictions, 16, 20, 51, 60, 62–63, 66, 71, 76, 132, 144, 148, 217n8, 227n17 272 272  Index of Subjects fundamentals, 10, 15, 26, 85–86, 97, 104–106, 112, 137–138, 144, 204, 224n13, 228n26, 237n13 (see also shocks, fundamental; stock market, fundamental view of) GDP, see gross domestic product general theory, 23–29, 144, 182 golden rule of capital accumulation, 177, 241n22 government, 14, 16, 18–19, 23, 26, 31, 36–37, 40, 42, 45, 90, 93–96, 103–106, 147, 160–162, 165–166, 170–172, 174–180, 182, 184, 191–196, 199, 204–206, 212n26 government bonds, 179, 187 government debt, 92, 96, 145, 147, 175–177, 183, 193, 196 debt deflation, 96, 148 maturity structure of, 180, 238n26 government expenditure, 14, 121, 157–174, 177–178, 181, 184, 235n7, 237n13 government investment expenditure, 180 (see also Government expenditure) government purchases, see Government expenditure government spending, see Government expenditure Gramm-Leach-Bliley Act, 94 Granger causality, 103–104, 107 Great Depression and Great Recession, 98–100 as a rare disaster, 93 causes of, 1, 67, 99, 100, 107 consequences of, 31, 105 description and explanation of, 60, 82, 86–87, 99, 158, 186 evidence from, 163–181 prevention of, 7, 46, 160, 182 Great Moderation, 6, 8, 112, 127, 145, 210n10 Great Recession (see also Great Depression and Great Recession) as a rare disaster, 93 causes of, 1, 6, 67, 104–107 consequences of, 2, 32, 45, 71, 120, 204 description and explanation of, 54, 82, 86–87, 134–135 evidence from, 124–125 forecasting, 103, 112 slow recovery from, 13, 143 Great Stagflation, 31–32, 37–38 gross domestic product GDP futures, 200–201 nominal GDP targeting, 199–200 potential GDP, 110, 121, 126–128, 150, 221n23 Harberger Triangle, 67, 221n23 hours worked, 57, 216n1 Hodrick-Prescott filter, 50, 218n9, 237n9 (see also time series filtering) hysteresis, 232n9, 234n18 identification, 172 inflation and Farmer Monetary Model, 112, 127, 140–142, 149–153 and Great Stagflation, 31, 37 and interest rates, 111–112, 114, 117–119, 131, 140, 202, 234n17 (see also Taylor Rule) and new financial policy, 190, 197, 206 and New Keynesian economics, 30, 35, 63–64, 109–130, 133, 141–142, 203, 220n15 and Phillips Curve, 33, 35–45, 63, 114, 136 and unconventional monetary policy, 179, 184–186, 190 low and stable, 6, 16, 109–110, 185, 205–206   273 Index of Subjects  273 in IS-LM model, 25 persistence of, 63–64, 70, 86, 116, 118, 133, 220n15 targeting of, 6, 16, 111, 185, 190, 201–205, 210n8 institutional design, 4, 6–8 interest rate (see also forward, guidance; inflation and interest rates; Taylor Rule) and assets, 15, 19, 83, 136, 197, 238n16 and Farmer Monetary Model, 112, 132–136, 140, 144, 149–153 and IS-LM, 25, 179, 202 and New Keynesian economics, 30, 110, 113, 116, 119, 127–131, 136, 141, 203, 205 and policy, 16, 19, 109, 111, 131–132, 179, 182–183, 191, 197, 202, 206, 237n15 Federal Funds rate, 117–119, 239n2 negative, 202, 239n2 persistent, 116–118, 134, 143, 202, 220n15 real interest rate, 113, 134, 143, 177, 234n17, 240n20, 241n22 zero lower bound, 7, 16–17, 110, 170–171, 184, 197, 239n2 investment, 3, 17, 48, 50, 57, 91, 113, 114, 157–161, 165–168, 171, 235n7, 237n9 (see also government investment expenditure) IS-LM model, 13–14, 25–26, 132, 181, 202, 212n21 John Flemming Memorial Lecture, 188 Keynesian cross, 156, 174 Keynesian economics, 24–25, 34, 52, 154–156, 170, 177–181 King Canute, 145 labor force, 53, 55, 75, 79, 81, 87, 158, 216n4 labor force participation rate, 54–57, 174–175, 231n20 Lehman Brothers, 100, 102, 112, 186 leverage, 135 Life cycle hypothesis, 165, 212n23 long run (see also neoclassical synthesis) and classical economics, 25, 59, 201, 212n21 and Farmer Monetary Model, 132 and Keynesian economics, 52 and New Keynesian economics, 16, 59, 202 and inflation, 38–41, 201 and interest rates, 132 and multiple equilibria, 86 and Phillips Curve, 45, 216n19 and policy, 16, 105, 132, 194–195, 201, 216n17 and price adjustment, 34, 45, 59 and stock market, 102 and unemployment, 16, 38–41, 102, 195, 201 macroprudential policy, 20, 135, 190, 205 marginal propensity to consume, 157, 160, 163, 165, 236n8 markets complete, 93–94, 204, 227n17 continuous clearing and equilibrium approach, 48, 51–52, 56–57, 60, 65, 71, 154, 217n3 free, 2, 7–9, 74–75, 199 incomplete, 93–94, 205–206, 211n17, 2243n10, 226n9 Massachusetts Institute of Technology, 27, 51 gang of, 13–14 MBS, see mortgage-backed securities menu costs, 51, 62, 65, 71, 136 274 274  Index of Subjects MIT, see Massachusetts Institute of Technology monetary neutrality, 132, 216n17 monetary policy, 6, 19–23, 32–33, 56, 74, 109, 118, 127, 131, 162, 193–198 (see also interest rate; money supply) monetary policy committee, 194, 197, 203 monetary regime, 37–38 floating exchange rate system, 37–38 gold exchange standard, 6–7, 37–38, 45 monetary transmission mechanism, 131 money supply, 42, 52, 62–63, 131–132, 184, 205 moral hazard, 177, 242n33 mortgage-backed securities, 187–189 MPC, see monetary policy committee multiple equilibria, 25–26, 71, 138–140, 144, 154, 203, 225n16, 234n1 (see also steady-state equilibrium) multiplier, 14, 155, 158, 160, 163, 169, 170–174, 236n8 NAIRU, see unemployment, non-accelerating inflation rate of natural rate hypothesis, 20, 32–33, 39, 42–45, 65–67, 141–145, 202 (see also unemployment, natural rate of) neoclassical synthesis, 13, 25–26, 34, 51, 58–59, 66, 143, 201, 212n21 new financial policy, 1, 30, 207 (see also stock market interventions) New Keynesian economics (see also consumption function; inflation; interest rate; neoclassical synthesis; Taylor Rule) and beliefs, 29, 84, 138 and Calvo Fairy, 62–63, 115, 219n11 and cost of recessions, 66 and frictions, 51, 60–61, 66, 71, 217n8 and Great Moderation, 112 and market clearing, 51, 56, 65, 71 and natural rate hypothesis, 33, 45, 52, 65–66, 74, 82, 86, 120, 124, 126, 141, 143, 202 and New Keynesian IS Curve, 113, 128–129, 133–134 and New Keynesian Phillips Curve, 35–36, 45, 113–115, 129, 136–137, 231n18 and persistence, 116, 121–122, 126, 133, 143, 220n15, 231n18, 232n8 and policy, 14, 16, 46, 112, 127, 136, 170, 202–205 and self-stabilization, 51–52, 111–112, 119, 141, 145 and sticky prices, 60–64, 71–72, 75, 82, 115 (see also menu costs) and stock market, 67, 72, 91, 232n8 and unemployment, 16, 30, 33, 45, 51, 65–66, 72–75, 82, 86, 130, 136, 141–142, 203 and uniqueness of equilibrium, 26, 66, 72, 130, 203 model of, 127–130, 229n1 NRH, see natural rate hypothesis Okun’s Law, 110, 117, 229n3 Okun gap, 67 (see also Output gap) optimism, 11, 15, 69, 148–149, 158, 206 (see also confidence; pessimism)   275 Index of Subjects  275 output gap, 110–117, 128, 131–132, 135, 140–142, 150, 229n3 overlapping generations model, 27, 140, 213n27, 233n16 Pareto optimality, 8–10, 21, 29, 66, 74, 90, 95, 135, 144, 190, 206, 213n27, 226n13 participation complete, 91, 227n14 incomplete 10, 18, 94, 95–96, 135, 144–145, 184, 213n27, 227n14 permanent income, 146–148, 165, 201, 212n23, 234n22 pessimism, 1, 11, 69, 105, 114, 148–149 (see also confidence; optimism) Phillips Curve, 33–45, 62, 114, 132, 136, 143–145, 216n7, 216n19, 231n18 (see also New Keynesian economics) preferences conventional, 92–93, 225n4 exotic, 92–93, 226n7 present value, 15, 21, 146–149, 180, 192 price-to-earnings ratio, 98, 107, 190, 194–195, 227n17, 240n20 cyclically adjusted, 10, 97–98, 211n16 Ptolemy’s Theory 70–71 QE, see quantitative easing qualitative easing, 183–189 quantitative easing, 7, 146, 183–189, 200, 203–204, 240n8 Ramsey growth model, 48, 217n4 rare disaster, 93 rationing, 168–169 RBC, see real business cycle real business cycle, 28, 48–49, 52, 60, 75, 93, 127 reduced form, 116, 119, 127, 130, 140, 152–153 regression analysis, 63, 141, 233n12 (see also vector-autoregression) research program, 59, 70, 72 degenerative, 20, 70–71 hard core of, 35, 59, 72, 215n7 progressive, 70 protective belt of, 59, 70, 143 S&P 500, 19, 101–102, 168, 189, 228n21 Say’s Law, 31–32, 237n13 scanner data, 62–64, 219n13 search, 11, 57, 75, 79, 83 classical theory of, 65, 76–78, 222n4, 224n13 Keynesian theory of, 20, 76–78, 83–84, 121, 124, 126–127, 137–138, 157, 178, 223n5, 223n8, 224n13 technology of, 79, 81, 88, 223n10 self-correction, see self-stabilization self-fulfilling beliefs, 1, 11, 15, 27–28, 65, 69, 84–85, 105–107, 154, 179–180, 206 self-fulfilling prophecies, see self-fulfilling beliefs self-stabilization, 23–25, 28–31, 52, 59, 112, 119, 145 (see also stabilization policy) shocks fundamental, 26, 69, 95, 127–128, 150–151 nonfundamental, 95–96, 127–128, 150–151, 225n3, 226n12, 226n13 permanent, 120–126 productivity, 28 temporary, 121–125 to discount rate, 134 short run, 16, 25, 34, 45, 59, 201–202, 212n21 276 276  Index of Subjects socialism, 7 social planner, 3–4, 66, 73, 76, 80, 82, 143, 209n4, 223n10 sovereign wealth fund, 21, 191–193, 197–198, 206 stabilization policy, 165, 195, 209n7 steady-state equilibrium (see also long run) and classical economics, 51 and Farmer Monetary Model, 71, 132, 141 and Keynesian economics, 71, 181 and New Keynesian economics, 66, 111, 120, 141, 203 and multiple equilibria, 20, 60, 71, 138, 141, 154–155, 181, 203, 224n13, 235n4 and self-stabilization, 29, 111, 120, 123, 141, 194 and unique equilibrium, 38, 51, 154, 203, 234n17 optimality of, 66, 81 stickiness of inflation, see inflation of information, 219n13 of prices and wages, 11, 25, 34, 45, 59, 60–61, 64, 67, 72, 82, 87, 136, 144, 201 stock market and animal spirits, 97, 104–107, 180, 194–195, 199 and beliefs and expectations, 12, 69, 84, 98, 106 and consumption, 12, 100 and new financial policy, 183, 187–189 and New Keynesian economics, 67, 72, 91, 232n8 and unconventional monetary policy, 183 and unemployment, 12, 15, 19, 99–104, 107–108, 190, 195, 228n23 and wealth, 83–84, 134 animal spirits view of, 105–107 crash of, 67, 72, 99, 104, 107, 149, 158, 165, 183–184 (see also financial crisis) fundamental view of, 105–106 interventions in, 106, 121, 182, 193, 195–197, 205–206, 241n21 (see also new financial policy) volatility of, 10, 92 (see also excess volatility puzzle) structural form, 130, 152 sunspot, 26–28, 214n12, 225n3 SVAR, see vector-autoregression, structural SWF, see sovereign wealth fund taxes, 13, 143, 166, 172, 174, 176, 192 Taylor Rule, 113–114, 128–129, 131, 133, 135, 141, 150–151, 200, 234n17 Taylor Principle, 230n9 temporary equilibrium, 24 time series cointegrated, 102, 118–120, 228n24 filtering, 50, 52 (see also Hodrick-Prescott filter) nonstationary, 101, 143, 228n24, 230n13, 231n18 random walk, 143, 152, 211n16 (see also unit root) stationary, 118–120, 125, 138–139, 141, 143 trend, 50, 54, 56, 117, 122, 124, 131, 133, 175, 230n13 unit root, 102, 120, 125, 230n13, 231n17 (see also Random walk) treasury, 17–19, 105, 121, 165–166, 169–170, 180, 182, 191–198, 201   277 Index of Subjects  277 treasury securities, 10, 106, 187 (see also government bonds) Treasury bills, 17, 133–134, 180, 191 Treasury bonds, 17, 93, 134, 170, 189, 196 Treasury view, 165–168, 237n13 Trill, 200–201 non-accelerating inflation rate of, 231n18 persistent, 21, 29, 70, 86–87, 116 voluntary, 20, 29, 31–34, 47, 57, 60, 72 University of Pennsylvania, 26, 91, 154 unemployment (see also natural rate hypothesis) and aggregate demand, 25, 41, 52, 57, 83, 121, 144, 149, 170, 230n13 and animal spirits, 21, 52, 57, 71–73, 106, 155, 195 and beliefs, 57, 65, 69, 71, 143–144 and classical economics, 34, 47, 60, 64, 74 and financial crisis, 98–99 and fiscal policy, 36, 219n11, 239n27 and New Keynesian economics, 16, 30, 33, 45, 51, 65–66, 72–75, 82, 86, 130, 136, 141–142, 203 and stock market, 12, 15, 19, 99–104, 107–108, 190, 195, 228n23 and wealth, 15, 98–102, 107–108, 148 in long run, 16, 38–41, 102, 195, 201 insurance, 175, 177 involuntary, 29–34, 47, 51–52, 72, 83, 181, 195 natural rate of, 16, 20, 30–52, 65–66, 73–74, 80–87, 110, 116, 120–126, 132, 141–145, 195–196, 201–205, 223n8, 230n13, 234n20 VAR, see vector-autoregression VECM, see vector error correction model vector-autoregression, 64, 140–141 structural, 173–174 vector error correction model, 142 volatility, 6, 10, 12, 90, 179, 190, 196, 209n7, 224n13 Vulcan, 35 wage units, 158–161, 167–168, 201, 218n9, 237n9 wealth (see also sovereign wealth fund) and aggregate demand, 83, 170, 178, 201 and beliefs, 77, 83, 136, 179 (see also belief function) and consumption, 14–15, 165, 175, 178, 211n18, 212n23 (see also consumption function) and government debt, 147, 213n27 and inflation, 185 and policy, 201 and recessions, 1, 105–106 and stock market, 83–84, 134 and unemployment, 15, 98–102, 107–108, 148 distribution of, 3–4, ...  i PROSPERITY FOR ALL ii   iii PROSPERITY FOR ALL HOW TO PREVENT FINANCIAL CRISES ROGER E. A. FARMER iv Oxford University Press is a department of the University of Oxford It furthers... financial markets and guarantees prosperity for all 2 2  Prosperity for All The Role of the State The Great Recession that began in 2007 is still affecting all of us in ways that were unimaginable... wrong There is no excuse for a society that condemns 50% of its young people to a life of unemployment.15 We can and must seek prosperity for all 10 10  Prosperity for All Why the Financial Markets Fail