The Stock Market Crash of 2008 Caused the Great Recession

NBER WORKING PAPER SERIES

THE STOCK MARKET CRASH OF 2008 CAUSED THE GREAT RECESSION: THEORY AND EVIDENCE Roger Farmer Working Paper 17479 http://www.nber.org/papers/w17479

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

References: Ando, A., and F. Modigliani (1963): “The "Life Cycle" Hypothesis of Saving: Aggregate Implications and Tests,” American Economic Review, 53(1), 55—84. Bernanke, B. S. (2008): “Remarks to the Federal Reserve Bank of Atlanta Conference, Sea Island, Georgia,” http://www.federalreserve.gov/newsevents/speech/bernanke20080513.htm. Beyer, A., and R. E. A. Farmer (2003): “Identifying the Monetary Transmission Mechanism Using Structural Breaks,” European Central Bank Working Paper Series, No. 275. (2007): “Natural Rate Doubts,” Journal of Economic Dynamics and Control, 31(121), 797—825. Carlson, K. M., and R. W. Spencer (1975): “Crowding Out and its Critics,” Federal Reserve Bank of St. Loius, pp. 2—16. Clarida, R., J. Galí, and M. Gertler (2000): “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory,” Quarterly Journal of Economics, 115(1), 147—180. Farmer, R. E. A. (2008): “Old Keynesian Economics,” in Macroeconomics in the Small and the Large, ed. by R. E. A. Farmer, chap. 2, pp. 23—43. Edward Elgar, Cheltenham, UK. (2009): “Confidence, Crashes and Animal Spirits,” NBER WP no. 14846, Economic Journal (forthcoming). (2010a): “Animal Spirits, Persistent Unemployment and the Belief Function,” NBER Working Paper no. 16522 and CEPR Discussion Paper no. 8100., forthcoming in Frydman and Phelps (2012). 29 (2010b): Expectations, Employment and Prices. Oxford University Press, New York. (2010c): How the Economy Works: Confidence, Crashes and Selffulfilling Prophecies. Oxford University Press, New York. (2010d): “How to Reduce Unemployment: A New Policy Proposal„” Journal of Monetary Economics: Carnegie Rochester Conference Issue, 57(5), 557—572. (2011): “Animal Spirits, Rational Bubbles and Unemployment in an Old-Keynesian Model,” CEPR Discussion Paper, 8439. (December 30th 2008): “How to Prevent the Great Depression of 2009,” Financial Times, Economists’ Forum, http://blogs.ft.com/economistsforum/2008/12/how-to-prevent-thegreat-depression-of-2009/. Farmer, R. E. A., and D. Plotnikov (2010): “Does Fiscal Policy Matter? Blinder and Solow Revisited,” NBER Working Paper number 16644. Friedman, M. (1957): A Theory of the Consumption Function. Princeton University Press, Princeton, N.J. Frydman, R., and E. Phelps (2012): Foundations for a Macroeconomics of the Modern Economy. Princeton University Press, Princeton N.J. Galí, J. (2008): Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. Princeton University Press. Johansen, S. (1991): “Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregreeive Models,” Econometrica, 59, 1551—1580. Keynes, J. M. (1936): The General Theory of Employment, Interest and Money. MacMillan and Co., London and Basingstoke. 30 Lettau, M., and S. C. Ludvigson (2004): “Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption,” American Economic Review, 94(1), 276—299. Lubik, T. A., and F. Schorfheide (2004): “Testing for Indeterminacy: An Application to U.S. Monetary Policy,” American Economic Review, 94, 190—219. Lucas Jr., R. E. (1972): “Expectations and the Neutrality of Money,” Journal of Economic Theory, 4, 103—124. Mankiw, N. G. (2010): Macroeconomics. Worth, New York, Seventh Edition. Modigliani, F., and R. Brumberg (1954): “Utility analysis and the consumption function: An interpretation of cross-section data,” in PostKeynesian Economics, ed. by K. Kurihara. Rutgers University Press. Patinkin, D. (1956): Money Interest and Prices. The MIT Press, Cambridge, Massachusetts, second abridged edn. Pigou, A. C. (1943): “The Classical Stationary State,” Economic Journal, 53, 343—351. Rogerson, R., R. Shimer, and R. Wright (2005): “Search-Theoretic Models of the Labor Market: A Survey,” Journal of Economic Literature, 43, 959—988. Samuelson, P. A. (1948): Economics: an Introductory Analysis. McGraw Hill, New York. Sims, C. A., and T. Zha (2006): “Were There Regime Switches in US Monetary Policy?,” The American Economic Review, 96(1), 54—81. 31