Working Paper: CEPR ID: DP7526
Authors: Roger E. A. Farmer
Abstract: This paper uses a model with a continuum of equilibrium unemployment rates to explore the effectiveness of fiscal policy. The existence of multiple steady states is explained by a model of costly search and recruiting that leads to a situation of bilateral monopoly. Using this framework, I explain the current financial crisis as a shift to a high unemployment equilibrium, induced by the self-fulfilling beliefs of market participants about asset prices. Using this model, I ask two questions. 1) Can fiscal policy help us out of the crisis? 2) Is there an alternative to fiscal policy that is less costly and more effective? The answer to both questions is yes.
Keywords: financial crisis; fiscal policy; unemployment
JEL Codes: E24; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal policy (E62) | Unemployment (J64) |
| Market participants' beliefs about asset prices (G19) | Unemployment equilibrium (J64) |
| Market participants' beliefs about asset prices (G19) | Transition from low to high unemployment equilibrium (J64) |