Posted by: Dirk | October 7, 2008

How to model the financial crisis?

Recently, I have noted that most macroeconomic models have big difficulties to explain the ongoing financial crisis. Then, why try it? Well, models can be handy in explaining recessions and/or financial crisis. There might be so lessons that can be generalized, so that we learn about what is going on why. So far, the only thing I have seen on the net is Paul Krugman’s backward-bending demand curve in the financial assets market (discussed here by Brad DeLong). It looks like this:

This supply and demand schedule is surely nothing special. The only new thing is that the demand curve is backward-bending. And that’s not really new either, since this kind of curve exists in labor market theory. The question I ask myself is: what do you need that backward-bending shape for? Why not have a linear, downward-sloping demand curve for the time of euphoria and one that is lower for bad times. Like this:

So, in bad times you shift from the good equilibrium (price is high) to the bad one. The lower demand curve is flatter, since buyers are more price-sensitive in times of crisis. But this is not the point here. The point is: why complicated when simple does it?

Then, what is the general story? It seems that there is only a problem in the market for risky financial assets, since there is no connection to any other macroeconomic variable. From my point of view the sub-prime mess is connected to the particular constellation of the world economy.

Continue reading here.

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