Accordingly, the output gap and the inflation rate became a sufficient pair of statistics to monitor the economy. 6 In parallel, in the workhorse models of this period, the typical rigidities were simply those of sticky prices and monopolistic competition, which generated deviations from the flex-price equilibrium of the economy in response to exogenous shocks. 5 Financial engineering and innovation created new bridges from savers to borrowers and it seemed to many that credit markets were being well oiled by the financial sector. ![]() The long expansion in activity from the early 1990s to late 2008 was a period in which finance became both content and proud, perhaps through benign neglect. I shall argue tentatively that there is considerable scope for optimism over the micro-founded agenda and that some form of financial workhorse will emerge. In this paper I will try to show how micro-founded models can be extended to encompass real problems such as financial frictions, without necessarily sacrificing internal coherence and I will also consider the implications for monetary policy. 3 Many have argued that micro-foundations had always been built on a fault zone and thus were simply not likely to survive much of a shock. Such frictions would lead to time-varying endogenous wedges between different sets of interest rates and in which supply effects may impact on various interest rates and change aggregate demand and potential output levels. The current global financial crisis turned out to be another such earthquake and one positive result has been an explosion of work by macroeconomic modellers striving to develop micro-founded models with financial frictions. What I will try to show in this paper is that this latter approach allows the development of models that retain internal coherence and allow a better characterisation of the economic environment and hence can still be used for policy analysis. By contrast, the macroeconomic models with microfoundations that became popular in the 1990s attached more importance to internal (logical) coherence than to external realism per se. As per some heterodox and agent-based approaches, such models attached more importance to external realism than to internal coherence. Traditional economic models, which are heavily reliant on econometric estimation, were thought to fall foul of the Lucas Critique. The hope was that such models would be usable for policy analysis in terms of welfare because the fundamental relationships were stable in the face of changes in policy. The near loss of monetary control in the 1970s awakened an interest in macroeconomic theory for deriving aggregate behavioural equations from optimisation problems in which agents solved for intertemporal and intratemporal decision rules subject to an economy-wide resource or budget constraint. The subsequent development of macroeconomic stabilisation policy seemed to have been a huge success during the so-called post-war ‘Golden Age’, but cracks in the foundations ultimately undid the practice. The classic example is the impact of the Great Depression on the direction of economics, as it led to the development of an obligation for the government to run counter-cyclical economic policies and subsequently to the growth of national income accounting, which laid the basis for the development of macroeconomic modelling. 1 Such earthquakes test the robustness of established views and may lead to previously unanticipated directions for thought. ![]() The foundations of knowledge, which include language and economics, can be subject to intellectual earthquakes. Nordmeyer holds a Bachelor of Science in accounting, a Master of Arts in international management and a Master of Business Administration in finance.The Basque language is the despair of scholars and the most mysterious of all known languages. During her career, she has published business and technology-based articles and texts.
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