Modeling Extreme Instability

Abstract

We construct a coherent theory of extreme macro instability, an important macro phenomenon most recently experienced in the United States in 2008-09. The model is then used to identify significant policymaking lessons from the Great Recession. The analysis is part of the ongoing GEM Project that focuses on the generalization of rational price-mediated exchange from the marketplace to the workplace, uniquely microfounding causation from adverse nominal demand disturbances to involuntary job loss. It further draws upon two recent contributions to the literature that we believe have received inadequate attention. In the first, Nancy Stokey (2009) demonstrates that, as investors/lenders become uncertain about macro prospects, inaction becomes rational. In the second, Roger Farmer (2010a, 2010b) has usefully repackaged an old idea: Independent of economic fundamentals, investor confidence can influence, and is influenced by, the behavior of prices on asset exchanges.