The financial crisis starting in the US subprime sector, has spread world wide as a great recession. A hyperactive monetary and fiscal policy since the end of 2007 has aimed at preventing a further financial meltdown in the advanced countries. Some observers meanwhile maintain that a slow recovery appears to be on the horizon. It is still worthwhile however to explore the fragility and potentially destabilizing feedbacks of advanced macroeconomies, in particular in the context of a Keynesian disequilibrium model where such issues have rarely been treated so far.
As the history of macroeconomic dynamics and business cycles – which recently have been developed as boom - bust cycles – has taught us, fragilities and destabilizing feed backs are known to be potential features of all markets – the product markets, the labor market, and the financial markets. In this paper we will focus on the financial market. We use a Tobin-like macroeconomic portfolio approach, coupled with the interaction of heterogeneous agents on the financial market, to characterize the potential for financial market instability.
Though the study of the latter has been undertaken in many partial models, we focus here on the interconnectedness of the goods and the financial markets. Furthermore, we study what potential fiscal and monetary policies can have in stabilizing unstable macroeconomies. It was in particular Minsky (1982) who has put forward many ideas to stabilize an unstable economy. Besides specific Tobin type taxes we in particular propose a countercyclical monetary policy that focuses on the market for stocks as the measure of the state of confidence of an economy. Conventional types of Taylor rules are by contrast not too effective in stabilizing the economy, unless they are reformulated and take account of the risky assets traded in the financial markets. Dynamic tools and stability analysis are brought to bear to demonstrate the stabilizing effects of those suggested policies.
In the paper we extend the portfolio model of Flaschel, Malikane and Proa˜no (2009), which coupled a dynamic multiplier process with the dynamic of the stock market, towards the additional treatment of long-term bonds as a further risky asset and the term structure of interest rates dynamics this gives rise to. We then study the role that monetary (interest rate) policy can play in such a framework, which was completely ineffective in the portfolio approach of the earlier paper. To a certain degree this result also holds in the present framework, though this ineffectiveness can be overcome when the central bank is willing to act on the long end of the bond market in place of its short end or – in the present context even better – on the equity market as the market that here impacts the investment behavior of firms in particular and economic activity in general.
We show in this respect that the private sector of the economy is likely to be an unstable one, since its steady state is generally surrounded by centrifugal forces. These forces thus have to be tamed by appropriate fiscal and monetary policy measures. We show in this respect that a Tobin type tax of capital gains together with a long-term oriented monetary policy and an open market policy that trades in long-term bonds are capable of stabilizing the steady state of the economy.
In the next section we comment on and investigate the asset market structure considered in our model type by contrasting it with a traditional Keynesian approach presented in Turnovsky (1995). The model that is based on this structure of the financial markets is presented in section 3. We then investigate in section 4 the stability of the real-financial market interaction of the model. In section 5 we use this analysis to investigate what policy measures can improve the working of the private sector of the economy. Section 6 concludes.
