Keynesian disequilibrium dynamics: Estimated convergence, roads to instability and the emergence of complex business fluctuations

QFRC Research Paper, 2010
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We reformulate the traditional AS-AD growth model of the Neoclassical Synthesis (stage I) with a Taylor policy rule replacing the conventional LM-curve, with gradually adjusting wages as well as prices, and with perfect foresight on current inflation rates and an adaptively revised notion of an inflationary climate in which the economy is operating. We compare this approach with the New Keynesian approach, the Neoclassical Synthesis, stage II, with staggered price and wage setting and find various common components, yet with radically different dynamic implications due to our treatment of the forward-looking part of our wage-price spiral. We show for a system estimate of our model that it implies qualitatively local asymptotic stability and when its estimated form is simulated in response to isolated shocks strongly damped business fluctuations, due to a stable interaction of goods market dynamics with the interest rate policy of the central bank and due to a normal working of a real-wage feedback chain. These results are however endangered â leading in fact to economic breakdown â when there is a global floor to money wage inflation rates. In this case, the return of some money wage flexibility in deep depressions is of help in restoring viability of the model, thereby even avoiding explosive dynamics and the collapse of the economy. This situation leads to viable, but complex business fluctuations
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