Financial Institutions, Economic Policy, and the Dynamic Behavior of the Economy

Abstract

Schumpeter asserted that there were two types of business cycle theories: one in which cycles reflected dampened economic behavior and another in which cycles reflect explosive economic behavior. Both of these theories allowed that cycles could be either monotonic or oscillating. In this working paper, Domenico Delli Gatti, Mauro Gallegati, and Levy Institute Distinguished Scholar Hyman P. Minsky expand the alternative types of theory to three by adding one in which cycles reflect nonoscillating time series, wavelike motions, and incoherent behavior, such as those witnessed in times of runaway inflation and debt deflations.

In Gatti, Gallegati, and Minsky's business cycle theory, cycles result from the combination of endogenous interactions that can lead to incoherence" and the effects of institutions to contain these tendencies in the economy. The authors construct an accelerator-multiplier model that reflects the idea that times series that can generate smooth growth and well-behaved cycles as possible transitory results of the economic process, but that also allow for intermittent conditions conducive to the emergence of incoherence or turbulence." This turbulence, however, can be contained by institutional factors that act as circuit breakers on the economy. Whenever institutionally determined values dominate endogenously determined values, the path of the economy is broken and an interactive process, which starts with new initial conditions, generates future values. Specifically, whenever the economy threatens to behave incoherently, these stabilizers, whether built-in or activated by government authority, prevent the economy from continuing on the prior determined path.

JEL Classification: E32, E44