The Stock Market Crash of 2008 Caused the Great Recession

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NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2011

This paper was prepared as a Plenary Address to the 17th International Conference in Economics and Finance, held at the Federal Reserve Bank of San Francisco, June 29th-July 1st 2011. I would like to thank the Society for Computational Economics and the Federal Reserve Bank of San Francisco for supporting this event and the organizers, Richard Dennis and Kevin Lansing, for inviting me to present my work. I would also like to thank Dmitry Plotnikov of UCLA for his invaluable research assistance. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research. © 2011 by Roger Farmer. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

The Stock Market Crash of 2008 Caused the Great Recession: Theory and Evidence Roger Farmer NBER Working Paper No. 17479 October 2011 JEL No. E0,E2 ABSTRACT This paper argues that the stock market crash of 2008, triggered by a collapse in house prices, caused the Great Recession. The paper has three parts. First, it provides evidence of a high correlation between the value of the stock market and the unemployment rate in U.S. data since 1929. Second, it compares a new model of the economy developed in recent papers and books by Farmer, with a classical model and with a textbook Keynesian approach. Third, it provides evidence that fiscal stimulus will not permanently restore full employment. In Farmer's model, as in the Keynesian model, employment is demand determined. But aggregate demand depends on wealth, not on income.

Roger Farmer UCLA Department of Economics Box 951477 Los Angeles, CA 90095-1477 and NBER



This paper is about the relationship between the stock market and the unemployment rate. It has three parts. First, I establish that there has been a high correlation between unemployment and the stock market in U.S. data since 1929. I use post-war quarterly data to estimate a bivariate time series model of unemployment and the real value of the stock market and I show that this model remained structurally stable before and after 1979. Second, I compare three simple theoretical models of the economy; a classical model, a Keynesian model and a “Farmerian model”, based on a series of recent books and papers (Farmer, 2008, 2009, 2010a,b,d,c, 2011). I evaluate the ability of each of these models to explain the Great Recession of 2008 and I argue that the Farmerian model provides the most plausible explanation of events. Third, I explain why I have advocated (Farmer, December 30th 2008) a policy of asset market intervention to restore full employment rather than a traditional Keynesian policy of fiscal stimulus. I present some evidence which shows that the Keynesian consumption function has not remained stable in the post-war period and I explain that evidence by showing that increases in government purchases since 1929 have been accompanied by offsetting changes in private consumption expenditure. The behavior of household consumption is consistent with the work of Friedman (1957) who showed that consumers respond to permanent income, or wealth, and not to transitory income. My work explains why high unemployment can persist for long periods of time. Although my explanation is rooted in Keynesian ideas, it goes beyond The General Theory (Keynes, 1936) by providing an original microfounded explanation for labor market failure. Unlike the new-Keynesian version of The General Theory, my explanation of recessions does not rely


on the assumption that prices are...
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