A 11 Why No Crunch From the Crash? (p. 2) David E. Runkle Economic Fluctuations Without Shocks to Fundamentals; Or, Does the Stock Market Dance to Its Own Music? (p. 8) S. Rao Aiyagari 1987 Contents (p. 25) Federal Reserve Bank of Minneapolis Quarterly Review Vol. 12, No. 1 ISSN 0271-5287 This publication primarily presents economic research aimed at improving policymaking by the Federal Reserve System and other governmental authorities. Produced in the Research Department. Edited by Preston J. Miller, Warren E. Weber, Kathleen S. Rolte, and Inga Velde. Graphic design by Phil Swenson and typesetting by Barbara Birr and Terri Desormey, Public Affairs Department. Address questions to the Research Department, Federal Reserve Bank, Minneapolis, Minnesota 55480 (telephone 612-340-2341). Articles may be reprinted if the source is credited and the Research Department is provided with copies of reprints. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Federal Reserve Bank of Minneapolis Quarterly Review Winter 1988 Economic Fluctuations Without Shocks to Fundamentals; Or, Does the Stock Market Dance to Its Own Music? S. Rao Aiyagari Senior Economist Research Department Federal Reserve Bank of Minneapolis I can calculate the motions of the heavenly bodies, Thus it is that most of the currently popular models of but not the madness of people. economic fluctuations are based on recurring random —Sir Isaac Newton shocks to economic fundamentals. These fundamentals consist, of course, of consumer tastes and the technolog- Last October's dramatic 23 percent decline in the U.S. ical possibilities available to firms. Shocks to consumer stock market sent shock waves through the economy, tastes affect the demands for various goods, whereas policymakers, and economists. Noneconomists and shocks to technology—by affecting costs of production- economists alike scurried to find some previously affect the supplies of various goods. In this way, these unforeseen new development that might explain the shocks give rise to fluctuations in prices and quantities. crash. Could the crash have been caused by the sudden In the absence of such continued random influences on appearance of a comet, by a supernova explosion in a tastes or technology, the currently popular models distant galaxy, or by a startling change in sunspot would predict that the economy would (in a reasonable activity? Or perhaps it was caused by psychological amount of time) settle down into a steady state, with no factors? Until recently, most economists would have fluctuations whatsoever.1 pooh-poohed such ideas as crazy. The stock market crash has revived interest in the To an economist (and also to market analysts on possibility of explaining fluctuations without such Wall Street) it seems natural to look for changes in shocks to fundamentals. One clear reason for this consumer tastes or technological factors as possible renewed interest has been the inability of economists or explanations. After all, one would expect that a sudden market analysts to find any new developments in tastes shift in consumer tastes toward eating out would drive or technology which could explain a crash of that up the stocks of fast-food chains and restaurants or magnitude. The appeal to psychological factors or, in that a new technological development in the computer general, random factors unrelated to fundamentals is, industry would drive up the stocks of computer firms. however, not new. In 1936, toward the end of the Great (This surely explains why a considerable amount of Depression, John Maynard Keynes published his classic market research on Wall Street consists of keeping General Theory of Employment, Interest, and Money, in track of technological developments and shifts in which he attributed business fluctuations not to random consumer trends.) It is not easy, however, to see why there should be any relationship between extraterres- trial happenings and new developments in consumer *For a recent example of one such model, see Prescott 1986. The tastes or technology. fluctuations in Prescott's model are driven by shocks to technology. 8 S. Rao Aiyagari Intrinsic Fluctuations shocks to tastes or technology, but to the animal spirits be several stable paths for the economy along which of investors. That is, investors may be seized by moods beliefs are self-fulfilling. Among these, some involve of optimistic or pessimistic expectations which bear no high employment and output whereas others involve necessary relation to any changes in tastes or tech- low employment and output, depending on whether nology. Keynes also asserted that such expectations on expectations are optimistic or pessimistic. In addition, the part of investors need not necessarily be irrational. there are many fluctuating paths corresponding to The moods of optimism or pessimism can cause inves- changing moods of optimism and pessimism. I argue tors to either expand or contract investment spending; that the low employment and output situation has some this, in turn, can lead to either an overall economic resemblance to the widespread lack of confidence and expansion or a contraction, thereby justifying the opti- consequent breakdown of market interactions that mistic or pessimistic expectations. Thus, these animal seem to characterize deep economic depressions. spirits can become self-fulfilling and hence be rational.2 Can such models explain the qualitative and quan- This alternative view of business fluctuations may be titative properties of economic fluctuations in real described as nonfundamental, intrinsic, or endogenous. economies? Perhaps. But I attempt no such explana- In this article I explain how economic fluctuations tions here, since the models described are chosen for can occur without shocks to fundamentals. This is not to their expositional simplicity rather than their ability to say that taste or technology shocks do not exist or that explain observed business fluctuations. I believe it is they are totally unimportant. Instead, the purpose here much too early to judge the empirical applicability of is to try and understand whether there exist forces these models, for only recently have economists started intrinsic to an economic system that tend toward in- analyzing such models. Further development and elab- stability; whether such instability is bad from the point oration of such models may prove to be empirically of view of economic welfare; and, if so, what sorts of useful, in addition to being theoretically insightful. policies or institutions may be set in place to avoid such Are there any policy implications that emerge from instability and put the economy on a steady course.3 the study of these models? Yes, although these impli- To explain these issues, I describe two models that cations are subject to some important qualifications. I illustrate intrinsic fluctuations and the role of animal show that for each model there exist very simple spirits. Both models are simplified versions of existing policies which can eliminate all fluctuations and set the ones that are part of the burgeoning literature on economy on a unique stable course. In addition, for the intrinsic fluctuations. Throughout the paper, the em- frictional unemployment model I show that such a phasis is on explaining how such fluctuations can arise policy can move the economy from a state of low in an environment in which the economic fundamentals employment and output to one of high employment and consisting of tastes and technology are unchanging output in which many people are better off and none is over time. Further, in both models, expectations are worse off. assumed to be rational. Without this assumption, one can explain anything, given a sufficiently perverse or A Stock Price Model irrational view of the world. Requiring beliefs to be In this section I describe and analyze a simple model of rational imposes a notion of consistency between stock price determination and then discuss an appropri- beliefs and reality and rules out explanations based on a ate stabilization policy. pathological view of the world. The first model described is a simple model of stock price determination in which consumers may hold 2 Expectations are said to be rational if beliefs regarding possible future many possible sets of beliefs that may be self-fulfilling events are (probabilistically) correct, that is, verified by the actual future course and hence rational. Some of these beliefs may even be of events. In a world without uncertainty, this amounts to having perfect based on random factors totally unrelated to the ob- foresight regarding future developments. 4 3 It should be clear that allowing for taste or technology shocks would only jective factors of tastes and technology. Furthermore, magnify the fluctuations. some of these beliefs lead the economy to a steady 4This may be viewed as capturing Keynes' notion of animal spirits. course while many others set the economy on a wildly Fluctuations resulting from such beliefs are often referred to as sunspot fluctuating path.5 fluctuations (see Cass and Shell 1983). 5 Models exhibiting these features have been studied extensively by many The second model described is a model of frictional people, among whom the following are prominent: Costas Azariadis (1981), unemployment in which production and exchange take David Cass and Karl Shell (1983), and Jean-Michel Grandmont (1985). 6 place in a decentralized fashion. 1 show that there may 6Models of this type were pioneered and studied by Peter Diamond (1984). 9 Consider an environment that is completely sta- The budget constraints faced by the consumer are tionary and in which there is one unit of a perfectly divisible asset (a stock, if you like) which pays a (2) cl(t) = w{[\-ll(t)]-p(t)s(t) constant and known stream of dividends forever. Consumers can purchase shares in this stock with a (3) c2(t+l) = w2[l-l2(t+l)] + [p<(t+l) + d]s(t).