A demand-driven search model with self-fulfilling expectations: The new ‘Farmerian’ framework under scrutiny

By Paolo Gelain and Marco Guerrazzi

http://d.repec.org/n?u=RePEc:pra:mprapa:55773&r=dge

In this paper, we implement Bayesian econometric techniques to analyze a theoretical framework built along the lines of Farmer’s micro-foundation of the General Theory. Specifically, we test the ability of a demand-driven search model with self-fulfilling expectations to match the behaviour of the US economy over the last thirty years. The main findings of our empirical investigation are the following. First, all over the period, our model fits data very well. Second, demand shocks are the most relevant in explaining the variability of concerned variables. In addition, our estimates reveal that a large negative demand shock caused the Great Recession via a sudden drop of confidence. Overall, those results are consistent with the main features of the New ‘Farmerian’ Economics as well as to latest demand-side explanations of the finance-induced recession.

Roger Farmer’s recent work has been causing quite a stir, especially as it seems to validate some the things that happened during the recent crisis. This paper provides an empirical test of Farmer’s theory and shows that he is indeed onto something.