Models Vs. Hand-Waving
By Arnold Kling
the answer to the question “what is the effect of a 1% increase in perceived risk on government bonds?” is exactly the same as the answer to the question “what is the effect of a 1% increase in expected inflation?”. At least, in this model, given my assumptions. Both result in the same 1% fall in the real risk-adjusted rate of interest on private saving and investment and the same rise in AD and real income.
He wonders why Keyensians are not cheering a political deadlock which would raise the risk premium on government debt.
I think most Keynesians would wave their hands and say that “A breakdown in trust in the financial system would be bad for aggregate demand.” I think that would be a better answer than saying that, “Well, in my model, an increase in the risk premium on government debt is expansionary, so that must be the right answer.”
A less satisfying answer is to say that “All securities are priced off of government debt. If the interest rate on government debt goes up, then all other rates go up.” I do not think that is what a model would say. If it is right, it is hand-waving.
Which suggests that hand-waving captures a truth that is not in models.