Yichuan Wang has an excellent post discussing the two ways to think about recessions. First goods and money:
Any macroeconomy can be broken down into two main markets: a real market for current goods and services, and a financial market for claims on future goods and services. For brevity, I will reduce the model for financial assets to the market for money, which, because of money’s role as a store of value and medium of exchange, captures the notion of “claims on goods”. To simplify further, I take all the markets for goods and reduce them down to one composite market, say, for apples. From this caricature, we can start thinking about how markets fit together.
In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to spend their cash and apple balances. Apples are transacted, bellies are filled, and life is good.
But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren’t consumed.
And then adding financial markets:
The goods market by itself is not enough to generate a recession with a general glut of goods. Only when there is the possibility of excess demand in money markets can recessions actually occur. Therefore the market for money is what gives a macroeconomy its business cycle feel. This is why money is so important for macro — fluctuations in the money market are the proximate cause for any general fluctuation in the goods market. This is why, as Miles Kimball says, money is the “deep magic” of macro. While this “apples and money” approach is the canonical presentation of general equilibrium, it is not the only representation. For another interpretation, think about what the financial market really is. Since it represents the entire universe of claims on future goods, finance can be understood as a veil between the present and the future. So instead of focusing on the relationship between goods and financial markets at one point in time, we can cut out the middle man and instead think of general equilibrium as a sequence of goods markets that occur across multiple points in time. In this version, there is no financial market per se, but buying an apple in “tomorrow’s goods market” represents buying a financial contract in the canonical model. Therefore, instead of thinking about the markets for goods and money, we can instead think about the markets for goods today and tomorrow.
The same excess supply and demand relationship works in this model. If there is an excess supply of goods today, then it must mean that there’s an excess demand for goods tomorrow. So we get a corollary to the first diagnosis of recessions: If there is an excess supply of goods today, it must be the result of an excess demand for goods tomorrow.
The first definition is something I associated with monetarists like Nick Rowe, and the second seems New Keynesian. Monetarists tend to worry that the second approach doesn’t pin down the price level:
Each of these stories has its own strength. Since the first goods-money model includes actual money, it can help us understand how the price level is determined through monetary neutrality. On the other hand, since general equilibrium is only concerned about relative prices, and since individual dollars are not transacted in the second story, the second story has no “goods/money” relative price — i.e. the second story cannot pin down an aggregate price level. However, the second story does a better job of being explicit about intertemporal choice. And for now, this intuition about relative prices between the past and the future will be powerful enough that I will focus on this second approach.
I certainly like the Rovian goods and money story better than the intertemporal substitution story, but I greatly prefer a third approach; labor and money. Indeed I don’t even like the definition of “recessions” that Yichuan starts off with. I don’t see the problem during recessions as being excess supply of goods. Or goods that are not consumed. Rather the goods market seems to be in equilibrium, it’s just that equilibrium output has fallen. I see excess supply of labor as the key characteristic of recessions, at least demand-side recessions. Yes, in theory output could drop while we remained at full employment due to falling productivity, but how often does that occur in the US? In practice, recessions mean excess unemployment.
So my recession model is one where nominal wages are sticky, and monetary shocks cause aggregate nominal income to fall. That leads to less hours worked, and thus less employment. There is no need to assume disequilibrium in the goods market. Some object to sticky wage theories because real wages don’t seem to behave as predicted. Actually real wages are very countercyclical in flexible-price competitive industries such as commodity production. However, most industries are monopolistically competitive, and hence you really want to look at the ratio of hourly nominal wages to NGDP. And that does correlate quite closely with the unemployment rate.
To conclude, interest rates don’t matter. Any monetary shock that affects current NGDP will impact the ratio of wages to NGDP, and hence create a business cycle. Monetary policy can fix the problem without having any effect of interest rates; just stabilize the path of NGDP. That’s the fatal flaw in intertemporal models. They don’t pin down the price level or NGDP, and hence cannot explain the path of W/NGDP, or the business cycle itself.
PS. I just got back from a week in Australia, and will gradually try to address a mountain of comments.