What’s Right with Macroeconomics?

What’s Right with Macroeconomics?

The Cournot Centre series

Edited by Robert M. Solow and Jean-Philippe Touffut

Global crises are very rare events. After the Great Depression and the Great Stagflation, new macroeconomic paradigms associated with a new policy regime emerged. This book addresses how some macroeconomic ideas have failed, and examines which theories researchers should preserve and develop. It questions how the field of economics – still reeling from the global financial crisis initiated in the summer of 2007 – will respond.

Chapter 6: Booms and busts: New Keynesian and behavioural explanations

Paul De Grauwe

Subjects: economics and finance, methodology of economics


Capitalism is characterized by booms and busts, by periods of strong growth in output followed by periods of declines in economic growth. Every macroeconomic theory should attempt to explain these endemic business cycle movements. How does the New Keynesian (dynamic stochastic general equilibrium – DSGE) model explain booms and busts in economic activity? And how does an alternative, behavioural model explain these features? These are the questions analysed in this chapter. In order to answer such questions, it is useful to present some stylized facts about the cyclical movements of output. Figure 6.1 shows the movements of the output gap in the USA since 1960. We observe strong cyclical movements. They imply that there is strong autocorrelation in the output gap numbers, that is, the output gap in period t is strongly correlated with the output gap in period t_1. The intuition is that if there are cyclical movements, we will observe clustering of good and bad times. A positive (negative) output gap is likely to be followed by a positive (negative) output gap in the next period. That is what we find for the US output gap over the period 1960–2009: the autocorrelation coefficient is 0.94. Similar autocorrelation coefficients are found in other countries.

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