Complexity, Uncertainty, and Macroeconomic Policy in the Global Economy

Massachusetts Institute Of Technology, Cambridge MA

Investigators

Abstract

Complexity, Uncertainty, and Macroeconomic Policy in the Global Economy Intellectual Merit The large global demand for store-of-value financial instruments accelerated the pace of complex financial innovations. The enormous confusion and fear caused by the sudden unravelling of many of the markets which were built on these innovations played a central role in the recent global financial crisis. It is no coincidence that the most effective economic policies implemented during this episode targeted the alleviation of this fear and confusion by providing extensive public guarantees. The purpose of this project is to provide a formal underpinning to each of these elements within a macroeconomic framework: The global macroeconomic forces behind financial innovation, complexity, Knightian uncertainty (fear), and the optimal policy response in settings where these ingredients play a central role. The intellectual merit of this proposal is to provide a new perspective on the endogenous sources of systemic fragility in a modern and global financial system. The goal is to provide a new set of macroeconomic models in which financial innovation stems from global macroeconomic forces, and shocks arise from the complexity of the financial network and the panics caused by the unmeasurable exposures that can arise from interacting with the financial network during times of systemic distress. While the core of the project is theoretical, it will be context-based (i.e., use extensive financial data to support the specific modeling). The PI also intends to use the models as an organizing device to make proposals on the kind of data that needs to be collected to measure the buildup of systemic risk in a financial system. Broader Impact The broader impact of this proposal is to offer a foundation for a policy framework to deal with some of the most damaging aspects of financial crises and panics. Since the purpose of the project is to improve policy design, but to do so with formal models, its educational value beyond the specific models is to bring closer together the concerns of policymakers and the interests of Ph.D. students.