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The Great RecessionLessons for Central Bankers$
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Jacob Braude, Zvi Eckstein, Stanley Fischer, and Karnit Flug

Print publication date: 2013

Print ISBN-13: 9780262018340

Published to MIT Press Scholarship Online: January 2015

DOI: 10.7551/mitpress/9780262018340.001.0001

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Prolonged Dislocation and Financial Crises

Prolonged Dislocation and Financial Crises

(p.337) 12 Prolonged Dislocation and Financial Crises
The Great Recession

Frank Browne

Robert Kelly

The MIT Press

The optimal level of the capital stock occurs when the real interest rate equals the steady-state growth rate of the economy. Any factor that drives a wedge in this equality can cause prolonged economic dislocation and a misallocation of resources. The more prolonged the dislocation the greater the threat to financial stability. Economic dislocation drove misalignments in asset prices, but had particular effects on property markets in some of the peripheral countries that adopted the euro: Spain, Portugal, Ireland and Greece. The factor driving the wedge in these countries stemmed, firstly, from the dynamics that arose from the fact that these countries were coming from backgrounds of lower standards of living and price levels than those in the core of monetary union and, secondly, from the fact that the ECB's monetary policy bestowed low nominal interest rates on these peripheral countries. Hence real interest rates were very low relative to these countries’ high growth rates. The chapter's measure of economic dislocation can account for the financial-instability-induced output loss. There is a significant relationship between this measure and subsequent output loss both in the euro area and in a wider sample of 57 countries.

Keywords:   Monetary union, Convergence to core, Prolonged distortion, Resource misallocation, Financial instability

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