The great moderation and “falling off a cliff”: Neo-Kaldorian dynamics

Following the broad outlines of Kaldor (1940), we develop a simple non-convex Keynesian macroeconomic model. It has two stable short-run equilibria, achieved by expectations adjustment; shifting curves in the medium run can cause a jump from high employment equilibrium to stagnation. Such a leap can arise from endogenous declines in the demand/debt ratio occurring after persistent periods of high employment (cf. Minsky, 1982 and Kalecki, 1933). We thus provide an explanation of the U.S. economy “falling off a cliff” – perhaps as seen during 2007–2009 – as being due to the “Great Moderation” of 1985–2006; this interpretation is made more plausible by reference to empirical data. The model also allows for milder fluctuations. The model's asymmetries suggest the need for “pump-priming” by policy-makers to allow recovery after a steep recession. We use a synthesis of the rational and adaptive theories of expectation determination.

Research highlights
► Catastrophe theory informally describes an economy that can fall from prosperity to stagnation.
► This fall can occur endogenously due to a long period of relative prosperity.
► Prosperity promotes financial fragility and/or the over-accumulation of fixed capital.
► Milder cycles can occur, while policy can play either a positive or destructive role.
► Special attention is given to the role of expectations in the equilibration process.