The standard macroeconomic models have failed, by all the most important tests of scientific theory. They did not predict that the financial crisis would happen; and when it did, they understated its effects. Monetary authorities allowed bubbles to grow and focused on keeping inflation low, partly because the standard models suggested that low inflation was necessary and almost sufficient for efficiency and growth. After the crisis broke, policymakers relying on the models floundered. Notwithstanding the diversity of macroeconomics, the sum of these failures points to the need for a fundamental re-examination of the models—and a reassertion of the lessons of modern general equilibrium theory that were seemingly forgotten in the years leading up to the crisis. This paper first describes the failures of the standard models in broad terms, and then develops the economics of deep downturns, and shows that such downturns are endogenous. Further, the paper argues that there have been systemic changes to the structure of the economy that made the economy more vulnerable to crisis, contrary to what the standard models argued. Finally, the paper contrasts the policy implications of our framework with those of the standard models. 1.

earlier draft, and the (U.S.) National Science Foundation for research support. A number of commentators have suggested that central banks should reconsider the desirability of inflation targeting in the light of the global financial crisis. Early on, Paul DeGrauwe (2007) asserted that the crisis had “unveiled the fallacy ” of the consensus view in favor of inflation targeting as an approach; a little later, Axel Leijonhufvud (2008) argued that inflation targeting “has failed ” as a strategy, and that “the problems we now face are in large part due to this policy failure”; and more recently, Francesco Giavazzi and Alberto Giovannini (2010) have proposed that inflation targeting, as conventionally practiced, “can... increase the likelihood of a financial crisis.” How seriously should inflation-targeting central banks take these charges? I think it is important to distinguish between inflation targeting as such and the more specific doctrine — enunciated by some prominent proponents of inflation targeting, but not, in my view, a defining feature of this approach to the conduct of monetary policy — according to which central banks need not pay attention to asset prices, or more generally to concerns relating to financial stability, when making monetary policy decisions. I do not believe that the central claims that were made by proponents of inflation targeting on behalf of this approach are challenged in any direct way by the events of the crisis.

Recent events have underscored the importance of asset price booms and busts as sources of financial instability. Unsustainable property price appreciation figured prominently in the 2007–2009 financial crisis, in the 1997–1998 Asian financial crisis, and in Japan’s property market collapse in the early 1990s. Monetary policy has come under intense scrutiny as a possible factor

The housing and credit markets are closely linked. This paper presents VAR evidence that house prices can generate financial and business cycle dynamics. An increase in house prices leads to a boom in mortgage and real estate construction lending. Leverage decreases in the short run before rising at longer-run horizons across households and most financial intermediaries, irrespective of their primary funding source. To understand the results I construct a New-Keynesian model with financial frictions, the housing market and financial sector. Collateralized mortgage debt, endogenous default risk in construction lending and collateralized borrowing limits on the supply-side of credit are necessary to support the VAR evidence. The model can generate expectations-driven boom-bust cycles in the housing market, real economy and financial sector, consistent with popular accounts of the most recent crises and historical housing booms.

shadow banking?

In this paper, we attempt to identify the separate contributions of credit demand, supply of …nancial intermediation, and supply of funds to uctuations indicators of credit conditions and to uctuations in economic activity. We estimate a common factor model in which the six factors correspond to supply of funds, … nancial inter-mediation, credit demand, aggregate uncertainty, real economic activity, and ination. We use a simple model of …nancial intermediation to motivate restrictions on the factor loadings designed to identify supply of funds, uncertainty, credit demand and …nancial intermediation factors. We …nd that the supply of funds and …nancial intermediation factors explain most of the variation in interest rates spreads, while the …nancial inter-mediation and credit demand factors typically contribute to most of the uctuations in credit quantity variables. For credit indicators, the 2007-08 …nancial crisis appears to be largely due to a decline in the …nancial intermediation. However, this decline in nancial intermediation seems to have originated from output and uncertainty shocks, rather than shocks to …nancial intermediation itself. JEL classi…cation: E44 E51 C32 Many thanks to Nick Bloom and William Dunkelberg for supplying their data. We also thank Tim Fuerst, Kundan Kishore, and Peter VanderHart as well as seminar participants at the June 2010 Western Economic Association Meetings and the February 2011 Eastern Economic Association Meetings for helpful comments and suggestions. The views expressed in this paper are solely those of the authors and not those of the Federal Reserve Bank of Dallas or the Federal Reserve System.

In this paper, we estimate a six-state common factor model from sixty- ve monthly and quarterly macroeconomic time series. The six Many thanks to Nick Bloom and William Dunkelberg for supplying their data. We also thank Tim Fuerst, Kundan Kishore, and Peter VanderHart as well as seminar participants at the June 2010 Western Economic Association Meetings and the February 2011 Eastern Economic Association Meetings for helpful comments and suggestions. The views expressed

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Abstract This paper presents an empirical study of a potential asymmetry in the response of monetary policy to stock prices in the US. The main …nding is that while monetary policy reacts signi…cantly to stock price drops, no signi…cant reaction to stock price increases is found. This result is obtained by applying the method of identi…cation through heteroskedasticity to a daily dataset covering the period 1998-2008. The result is con…rmed in an estimated, augmented Taylor rule based on monthly data for the same period. The size of the estimated, asymmetric reaction is modest. The study constitutes an empirical contribution to the debate about the role of asset prices in monetary policy, which has seen a revival in the aftermath of the crisis. In particular, the results lend empirical support to recent claims that the pre-crisis approach to monetary policy implied an asymmetric policy stance towards stock price movements.

If the Eurozone follows the precedent of the 1930s, it will not survive. The attractions of escaping from the gold standard then were massive and they point to a strategy of devalue and default for today’s crisis countries. A fully-federal Europe with a banking union and a fiscal union is the best solution to this problem but is politically infeasible. However, it may be possible to underpin the Euro by a ‘Bretton-Woods compromise ’ that accepts a retreat from some aspects of deep economic integration since exit entails new risks of financial crisis that were not present eighty years ago. JEL Classification: F33; N14