Asset Markets, Portfolio Choice and Macroeconomic Activity

Asset Markets, Portfolio Choice and Macroeconomic Activity

Asset Markets, Portfolio Choice and Macroeconomic Activity A Keynesian Perspective Toichiro Asada Professor of Economics, Chuo University, Tokyo, Japan Peter Flaschel Professor Emeritus, Bielefeld University, Bielefeld, Germany Tarik Mouakil Research Associate, University of Cambridge, Cambridge, UK and Christian Proaño Assistant Professor of Economics, The New School for Social Research, New York, USA Palgrave macmillan

Toichiro Asada, Peter Flaschel, Tarik Mouakil and Christian Proaño 2011 Softcover reprint of the hardcover 1st edition 2011 978-0-230-29017-4 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6--10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2011 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-33133-8 ISBN 978-0-230-30777-3 (ebook) DOI 10.1057/9780230307773 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 20 19 18 17 16 15 14 13 12 11

Contents List of Figures List of Tables List of Abbreviations Preface viii ix x xi 1 General Introduction 1 Methodological premises 1 The Keynes Metzler Goodwin framework 3 Two Old Keynesian models 7 Outline of the book 9 2 Advances in AS AD Model Building: Real Disequilibria and Portfolio Choice 11 Introducing disequilibrium elements into the AS AD framework 11 Tobin s portfolio approach to macrodynamics 18 Outlook 26 3 Tobinian Stock-Flow Interactions in the KMG Framework 27 Introduction 27 The accounting framework 29 The extensive form of the model 31 Stock-flow consistency 41 The feedback channels of the model 43 Unleashed capitalism 48 Related literature 51 v

vi Contents 4 Analysis and Policy Implications of the KMG Tobin Model 62 Introduction 62 The intensive form of the model 62 Steady state considerations 66 Comparative statics of the asset markets 71 Local stability and instability 75 The emergence of damped business fluctuations under suitable policy measures 80 Conclusions and outlook 91 5 Tobinian Stock-Flow Interactions in the Mundell Fleming Model 93 Introduction 93 The accounting framework 94 Dynamics of the model 101 Inflation and capital account dynamics under interest and exchange rate pegs 112 Overshooting exchange rates and inflation dynamics 121 6 International Capital Flows: Two Extensions of the MFTobin Model 128 Introduction 128 International capital flows in the MFT model 128 International finance: some basic results 140 Capital flight and currency crises 146 A two-country Mundell Fleming Tobin world 149 Conclusion 157 7 Fiscal and Monetary Policy, Stocks and the Term Structure of Interest Rates 158 Introduction 158 Financial markets and the effectiveness of monetary policy 159

Contents vii Keynesian asset price dynamics and the multiplier 163 Stable real-financial market interactions? 166 Stabilizing an unstable economy: Tobin-type taxes, interest rate rules and open market policies 173 Conclusions and outlook 177 Mathematical Appendices and Notation 179 Appendix I.1 The law of motion for real wages 179 Appendix I.2 Computation of expected capital gains 179 Appendix II Comparative statics 180 Appendix III Proofs of the stability propositions 182 Appendix IV Proof of the policy theorem 192 Appendix V Notation 192 Notes 195 References 203 Author/Name Index 209 Subject Index 211

List of Figures 3.1 The market hierarchy and the repercussions of the model 44 3.2 Real wage feedback chains 1 and 3 for a depressed economy 47 3.3 Damped oscillations (top left) and the loss of local stability via Hopf bifurcations with respect to β π c, β πec and β p 49 3.4 A period doubling route to complex dynamics through an accelerating wage price spiral, augmented by downward money wage rigidity (with financial market accelerators still tranquil) 52 3.5 A family tree of accounting-based macromodels 53 4.1 LM BB curves 73 5.1 Foreign bonds stock equilibrium (B o > 0) 106 5.2 The special example of stable inflation and capital account dynamics 119 5.3 The case of centrifugal inflation and capital account dynamics 120 5.4 The Dornbusch overshooting exchange rate dynamics 126 6.1 Exchange rate determination on the international capital market 139 viii

List of Tables 3.1 Transactions flow matrix of the KMG Tobin model 30 3.2 Transactions flow matrix and corresponding equations 42 5.1 Social accounting matrix of the MFT model 95 5.2 Financial SAM of the MFT model 99 6.1 Financial SAM with capital flows 130 ix

List of Abbreviations AS AD CB CGE DAE DAS AD DSGD DSGE EMS FCGE FSAM GBR IMMPA IS LM IS LM BP KMG KMGT LM MFT NAIRU PCs PPP SAM SFC UIP Aggregate Supply Aggregate Demand Central Bank Computable General Equilibrium Department of Applied Economics Disequilibrium Aggregate Supply Aggregate Demand Dynamic Stochastic General Disequilibrium Dynamic Stochastic General Equilibrium European Monetary System Financial Computable General Equilibrium Financial Social Accounting Matrix Government Borrowing Restriction Integrated Macroeconomic Model for Poverty Analysis Investment/Saving Liquidity Preference/Money Investment/Saving Liquidity Preference/Money plus BP-curve Keynes Metzler Goodwin Keynes Metzler Goodwin Taylor Liquidity Preference/Money Mundell Fleming Tobin Non-Accelerating Inflation Rate of Unemployment Phillips curves Purchasing Power Parity Social Accounting Matrix Stock Flow Consistent Uncovered Interest Rate Parity x

Preface This book builds on what we have sketched as road ahead in the final chapter of Asada, Chiarella, Flaschel and Franke (2010). It reflects and puts into perspective from a post-keynesian angle the Keynes Metzler Goodwin (KMG) disequilibrium growth dynamics and also the various AS AD approaches that surround this model of demanddriven distributive cycles. It does this in particular with respect to those studies which explicitly deal with stock-flow consistency and the stock-flow interactions they imply, i.e., the need for specifying all macro budget equations and the asset accumulation equations they give rise to. We start from small models of the dynamics of aggregate demand and supply. Against this background we then reflect the KMG modelling framework in its methodological premises and its position concerning the modelling of Keynesian macrodynamics, which significantly distinguishes this approach from what is now called the new Keynesian D(ynamic) S(tochastic) G(eneral) E(equilibrium) paradigm. This paradigm insists on market clearing with respect to all real markets, makes use, in general, of a single representative household, in addition, makes use of perfect interest rate parity conditions in place of imperfect asset substitution and, above all, employs socalled rational expectations solutions in order to get by assumption a stable deterministic core dynamics around which the implications of stochastic shocks (ad shockeries) can then be considered. The resulting rocking horse methodology is in striking contrast to what we will pursue in this book, where we focus on feedback-channel guided dynamic analyses of endogenously generated, demand-driven distributive cycles in the context of heterogeneous expectations formation and with a particular focus on a Tobin portfolio module in addition to the original primarily real KMG modelling framework. The resulting model of KMG Tobin type will be discussed and analysed in core chapters of the book, after its detailed motivation has been provided in the first two chapters. This portfolio approach to KMG growth is formulated in closed economies in terms of stocks of financial assets demanded and supplied. It needs reformulation for xi

xii Preface open economies, since capital accounts are to be represented in terms of flows. To achieve this we build on the Mundell Fleming Tobin (MFT) portfolio approach of Chiarella, Flaschel, Franke and Semmler (2009) which simplifies the real side of the KMGT macroeconomy considerably, in order to focus on the analysis of stock-flow interactions for small open economies as well as for interacting two-country macrodynamics. The portfolio adjustment processes we introduce on the financial markets of these models of open economy macrodynamics are extended in the final chapter of the book to the treatment of more than one risky asset and the implied term structure of interest rates which was so far absent in the considered KMGT and MFT models where only equities and fix-price bonds were considered. We therefore sketch in this chapter again a road ahead for future research which significantly enriches the structure of the financial side of the economy. We hope that this book is capable of showing that there is a common core in the Keynesian literature (without any prefix), which in our case took its point of departure from Chiarella and Flaschel s (2000) critical overhaul of the achievements of the old neoclassical synthesis and which in other cases may be closer related to work of Kalecki in particular. We stress that their common view surely is that the new (Keynesian) neoclassical synthesis is devoid of issues that were of importance for both Keynes and Kalecki. TOICHIRO ASADA PETER FLASCHEL TARIK MOUAKIL CHRISTIAN PROAÑO