Keynesianism and fiscal policy during the financial crisis

Abstract

In this thesis I will look more closely at certain major events as they unfolded during the recent financial crisis, before I turn to discuss some of the assumptions underlying the economic models used to guide policy analysis, and see if these assumptions are supported by the data. Chapter 2 contains a short introduction to the history and development of macroeconomic theory, and provides some background needed to understand why there exists no clear consensus among economists regarding the most effective way to deal with economic slumps. In chapter 3, I go through what I believe are some of the main contributing factors to the financial crisis. Global trade imbalances and perverse incentives in the financial sector are central to this discussion. I go on to describe the different stages of the current crisis, and how it spread from the financial sector into the real economy. Finally, I devote some time to the various policy measures taken to combat the crisis. Traditional monetary and fiscal policy actions were implemented, as well as more experimental policies like quantitative easing. In chapter 4 I take a closer look at some of the assumptions made when constructing macroeconomic models, and see if these assumptions seem reasonable when confronted with data. In particular, I look at a traditional Keynesian consumption function and the more fashionable Euler equation approach which implies a random walk for consumption. After testing some assumptions which are vital to both forms of modeling consumption, I implement the results of these tests to form an economic system. This system is then exposed to shocks of different kinds to illustrate how we would expect the economy to adjust over time. All estimations have been carried out using OxMetrics 6 and PcGive version 13. These findings are then summarized in the conclusion of the thesis in chapter 5.