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In this volume, leading economists take on the sometimes-derided concept of competitiveness, demonstrating the value of systematic analysis in an area too often dominated by special interest groups who use (and abuse) the concept to advance hidden agendas.

The book covers problems relating to international macroeconomics and international finance. The first part develops new approaches to exchange rate modeling. The second part is a collection of papers on the theory and empirical analysis of monetary unions. The third part contains criticism of the mainstream macroeconomic models and proposes alternative modeling approaches --

In this paper we extend the behavioral macroeconomic model as proposed by De Grauwe (2012) to include a banking sector. The behavioral model takes the view that agents have limited cognitive limitations. As a result, it is rational to use simple forecasting rules and to subject the use of these rules to a fitness test. Agents then are driven to select the rule that performs best. The behavioral model produces endogenous and self-fulfilling movements of optimism and pessimism (animal spirits). Our main result is that the existence of banks intensifies these movements, creating a greater scope for booms and busts. Thus banks do not create but amplify animal spirits. The policy conclusion we derive from this result is that the central bank has an important responsibility for stabilizing output. Output stabilization is an instrument to "tame the animal spirits". This has the effect of improving the tradeoff between inflation and output volatility.

Cover -- Halftitle -- Title -- Copyright -- Contents -- Preface -- 1 A Behavioral Macroeconomic Model -- 1.1 Introduction -- 1.2 The Model -- 1.3 Introducing Heuristics in Forecasting Output -- 1.4 Heuristics and Selection Mechanism in Forecasting Inflation -- 1.5 Solving the Model -- 1.6 Animal Spirits, Learning, and Forgetfulness -- 1.7 Conditions for Animal Spirits to Arise -- 1.8 Two Different Business Cycle Theories: Behavioral Model -- 1.9 Two Different Business Cycle Theories: New Keynesian Model -- 1.10 Uncertainty and Risk -- 1.11 Credibility of Inflation Targeting and Animal Spirits -- 1.12 Different Types of Inertia -- 1.13 Animal Spirits in the Macroeconomic Literature -- 1.14 Conclusion -- Appendix 1: Parameter Values of the Calibrated Model -- Appendix 2: Matlab Code for the Behavioral Model -- Appendix 3: Some Thoughts on Methodology in Mainstream Macroeconomics -- 2 The Transmission of Shocks -- 2.1 Introduction -- 2.2 The Transmission of a Positive Productivity Shock -- 2.3 The Transmission of Interest Rate Shocks -- 2.4 Fiscal Policy Multipliers: How Much Do We Know? -- 2.5 Transmission under Perfect Credibility of Inflation Target -- 3 Trade-offs between Output and Inflation Variability -- 3.1 Introduction -- 3.2 Constructing Trade-offs -- 3.3 Trade-offs in the New Keynesian Rational Expectations (DSGE) Model -- 3.4 The Merits of Strict Inflation Targeting -- 4 Flexibility, Animal Spirits, and Stabilization -- 4.1 Introduction -- 4.2 Flexibility and Neutrality of Money -- 4.3 Flexibility and Stabilization -- 5 Animal Spirits and the Nature of Macroeconomic Shocks -- 5.1 Introduction -- 5.2 The Model with Only Supply or Demand Shocks -- 5.3 Trade-offs in the Supply-Shocks-Only Scenario -- 5.4 Trade-offs in the Demand-Shocks-Only Scenario -- 5.5 Conclusion -- 6 Stock Prices and Monetary Policy -- 6.1 Introduction

Frontmatter -- Contents -- Preface -- 1. A Behavioral Macroeconomic Model -- 2. The Transmission of Shocks -- 3. Trade-offs between Output and Inflation Variability -- 4. Flexibility, Animal Spirits, and Stabilization -- 5. Animal Spirits and the Nature of Macroeconomic Shocks -- 6. Stock Prices and Monetary Policy -- 7. Extensions of the Basic Model -- 8. Empirical Issues -- References -- Index

The sovereign debt crisis has made it clear that central banking is more than keeping inflation low. Central banks are also responsible for financial stability. An essential tool in maintaining financial stability is provided by the capacity of the central bank to be the lender of last resort in the banking system. In this paper I argue that the ECB should also be the lender of last resort in the government bond markets of the monetary union, very much like the central banks in countries that issue debt in their own currencies are. This is necessary to prevent countries from being pushed into bad equilibria by self-fulfilling fears of liquidity crises in a monetary union. I also survey the different arguments that have been formulated by opponents of the view that the ECB should be the lender of last resort in the government bond markets.

When entering a monetary union, member-countries change the nature of their sovereign debt in a fundamental way, i.e. they cease to have control over the currency in which their debt is issued. As a result, financial markets can force these countries' sovereigns into default. In this sense member countries of a monetary union are downgraded to the status of emerging economies. This makes the monetary union fragile and vulnerable to changing market sentiments. It also makes it possible that self-fulfilling multiple equilibria arise. I analyze the implications of this fragility for the governance of the Eurozone. I conclude that the new governance structure (ESM) does not sufficiently recognize this fragility. Some of the features of the new financial assistance are likely to increase this fragility. In addition, it is also likely to rip member-countries of their ability to use the automatic stabilizers during a recession. This is surely a step backward in the long history of social progress in Europe. I suggest a different approach to deal with these problems.

Capitalism is characterized by booms and busts. Periods of strong growth in output alternate with periods of declines in economic growth. Every macro-economic theory should attempt to explain these endemic business cycle movements. In this paper I present two paradigms that attempt to explain these booms and busts. One is the DSGE-paradigm in which agents have unlimited cognitive abilities. The other paradigm is a behavioural one in which agents are assumed to have limited cognitive abilities. These two types of models produce a radically different macroeconomic dynamics. I analyze these differences. I also study the different policy implications of these two paradigms

I distinguish two types of macroeconomic models. The first type are top-down models in which some or all agents are capable of understanding the whole picture and use this superior information to determine their optimal plans. The second type are bottom-up models in which all agents experience cognitive limitations. As a result, these agents are only capable of understanding and using small bits of information. These are models in which agents use simple rules of behavior. These models are not devoid of rationality. Agents in these models behave rationally in that they are willing to learn from their mistakes. These two types of models produce a radically different macroeconomic dynamics. I analyze these differences.

DSGE-models have become important tools of analysis not only in academia but increasingly in the board rooms of central banks. The success of these models has much to do with the coherence of the intellectual framework it provides. The limitations of these models come from the fact that they make very strong assumptions about the cognitive abilities of agents in understanding the underlying model. In this paper we relax this strong assumption. We develop a stylized DSGE-model in which individuals use simple rules of thumb (heuristics) to forecast the future inflation and output gap. We compare this model with the rational expectations version of the same underlying model. We find that the dynamics predicted by the heuristic model differs from the rational expectations version in some important respects, in particular in their capacity to produce endogenous economic cycles.