1 How will the Financial Crisis change Macro-Economics? By C.A.E. Goodhart Financial Markets Group, London School of Economics

2 1.History of Thought A.Keynesian Analysis 1) Keynes G.T. (1936) Aggregate (effective) demand and aggregate supply Supply side, reverse L shape History, plus depressing effect of declining prices (Pigou, or real balance effect). Codified as IS/LM 2) National Income data, ) Philips curve, (1958), and output gap 4)I + X + G = S + M + T (Deficits = Surpluses) plus computers gives us National Income models in 1960s 5) Fiscal multiplier clear vs uncertain interest elasticity

3 B. Keynes vs Monetarism and Lucas 6) Monetarism vs Keynes in 1960s Stability of demand for money function vs stability of Keynesian models 7) Vertical Phillips curve and importance of expectations 8) Lucasian critique of N.I. models, no micro-foundation, need for rational expectations Agents optimise over rationally expected future 9) Constraints, Credit, Habits, excessive response of C to I.

4 C. DSGE 10) How to deal with diversity; how to make optimising agent model tractable? Answer representative agent, plus transversality condition. 11) Transversality condition rules out:- (a) Default (b) Credit risk premia (c) Banks (d) Money! Yet such DSGE models used by Central Banks (12)DSGE models are RBC models, where shocks occur only to productivity and preferences, e.g. time preference, plus price/wage stickiness (Calvo pricing), so monetary policy (Taylor reaction function) affects real variables. Woodford Interest and Prices (2003) (13)Interest rate effects clear vs uncertain fiscal multiplier (14) Complete disconnect between macro-economics (no default) and Finance, where PoD determines asset pricing

5 2. Where are we now after Crisis? 1)Can no longer use representative agent plus transversality. A continuum of agents with different risk aversion, so variations over time in default rates. Models beginning to adopt this. (Woodford, Gertler) 2)Inclusion of risk premia into model. (Curdia and Woodford) 3)Measuring and modelling systemic risk (Brunnermeier, CoVar; Acharya, Systemic Expected Shortfall) 4)Monetary Theory (R. Wright, Modern Monetarism, vs Credit Theory) 5)Gary Gorton and the run on the Repo 6) Macro-economics will reunite with Finance theory.