The financial system and the natural real interest rate: towards a ‘new benchmark theory model’

Abstract:

The 2008 financial crisis revealed serious flaws in the models that macroeconomists use to research, inform policy, and teach graduate students. In this paper we seek to find simple additions to the existing benchmark model that might let us answer three questions. What caused the boom and crisis? Why has the recovery been slow? And, how should policy respond to that slow recovery? We argue that it is necessary to add financial frictions to the benchmark model. This allows us to study the effects of leveraged financial institutions, and of a yield curve based on preferred habitats. Such features will cause endogenous changes in the natural real interest rate and the spread between that interest rate and the rate which influences expenditure decisions. They are likely to radically change the way in which the model responds to shocks. We point to some promising models that incorporate these features.