The Stock Market Model: A New Foundation for Economic and Monetary Policy.

Andrew Smithers
American Affairs, 1st June 2022

Economic policy aims to preserve stability by keeping inflation stable and unemployment at historically low levels. Decisions about how to achieve these aims are inevitably based on some theo-ry, and these theories fall into two main groups: those which are usually described as neo-Keynesian, and those based on dynamic stochastic general equilibrium (DSGE) models. For all practical purposes, howev-er, this division does not result in central bankers having to choose between different theories when making policy decisions. Several funda-mental assumptions are common to both groups, including the view that the day-to-day job of economic management is simple in theory, even if difficult in practice. It is agreed that there is only one equilibrium which must be maintained to preserve stability, and this is the balance between intentions (ex ante) to save and to invest. Keynes showed that the economy did not always achieve this balance through prudent adjust-ments of short-term interest rates; sometimes, in conditions he termed a liquidity trap, it is also necessary to boost demand through fiscal policy by increasing the size of the budget deficit. This conclusion is common to both the neo-Keynesian and DSGE approaches, and they also agree that if this ex ante balance between savings and investment is main-tained, it is sufficient to achieve stability. Consensus economic theories have therefore been labeled as “one deviation at a time models.”

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The Stock Market Model: A New Foundation for Economic and Monetary Policy