Imperfect Knowledge, Asset Price Swings and Structural Slumps: A Cointegrated VAR Analysis of Their Interdependence

Abstract

This paper discusses interactions between speculative behavior in the currency markets and aggregate ‡uctuations in the real economy. It builds on the Structural Slumps theory in Phelps (1994) and the recent theory of Imperfect Knowledge Economics in Frydman and Goldberg (2007). The former emphasizes real interest rates and real exchange rates as potentially important determinants underlying the persistent ‡uctuations in aggregate activities, and the latter provides the conditions under which speculative behavior in currency markets generates such persistence. The paper argues that by combing the two theories we can shed new light on the two-way interdependence between persistent swings in asset markets and persistent ‡uctuations in the real economy. In particular, we may improve our understanding of the mechanisms behind the long recurrent spells of high unemployment that continue to mar our economies. � The views in this paper are strongly in‡uenced by previous and ongoing research with Roman Frydman, Michael Goldberg and Soren Johansen. I am deeply grateful to Roman and Michael for sharing with me their profound insight in international macro and how imperfect knowledge economics can resolve its many empirical puzzles and to my son, Mikael Juselius, for numerous valuable comments on an early version of this paper.