DP9974 Macroeconomics after the crisis ? hedgehog or fox?
Following the financial crisis of 2008/9, there has been renewed interest in what Greenwald and Stiglitz dubbed ?pecuniary externalities?. Two that affect borrowers and lenders balance sheets in pro-cyclical fashion are described, along with measures that might help curb their destabilising effects. These ?pecuniary externalities? can be thought of as the unintended macroeconomic consequences of market conventions designed to check moral hazard.
The issue of moral hazard is explicitly discussed in the context of a simple model of insurance, where there is no Arrow Debreu equilibrium to allocate risk efficiently; but there is a ?noisy? mixed-strategy Nash equilibrium. Our simple example is designed to reinforce the point made by Greenwald and Stiglitz (1986) ? that when externalities are present, leaving things to the market may not be ?constrained Pareto efficient?.
While Central Bank policy may have shifted radically now that stability is an explicit objective of policy, the same cannot be said of the econometric models being used for macroeconomic forecasting ? even those in Central Banks!