2nd Year Macroeconomics Tutorials, 2008-9Kate Doornik: kate.doornik@sbs.ox.ac.uk

The tutorials will follow closely the lectures given by Simon Wren-Lewis et al on Mon/Tues/Weds mornings (see Intranet for timetable, as well as lecture slides, additional readings and information on the exam). You are expected to attend all these lectures.

There will be eight tutorials, provisionally following this sequence (we may need to push some earlier topics back)

1. Supply side: equilibrium with flexible prices, wage and price setting. Small open economies: Swan Diagram, trade imbalances.

2. New Keynesian theory (explanations for price rigidity), Phillips curves, ‘three equation model’, the rational expectations revolution.

3. Exchange rate dynamics, exchange rate regimes4. Monetary policy: Monetarism, active monetary policy, Time inconsistency5. Fiscal policy: short term stabilization, Fiscal Policy rules6. Intertemporal Macro 1: consumption7. Intertemporal Macro 2: Real Business Cycle model8. Growth: Solow etc, endogenous growth

Recommended textbooks:

The best textbook for the course in terms of level and coverage is: Carlin and Soskice Macroeconomics: Imperfections, Institutions and Polices

We will follow this as far as possible and you need easy access to a copy.

Other recommended textbooks Mankiw Macroeconomics (generally too easy now, but useful on some topics) Burda and Wyplosz Macroeconomics: A European text (same comment) Krugman and Obstfeld International Macroeconomics (useful additional

coverage on open economy macroeconomics) Romer Advanced Macroeconomics (for Intertemporal Macro) Charles Jones Introduction to Economic Growth (for Growth, introductory) Barro and Sala-i-Martin Economic Growth (for Growth, more advanced)

Each week I will set some ‘short answer’ questions and a couple of essay questions. The answers that you have to submit to me in advance are marked (*). These will be either three short questions or one essay question, on alternate weeks. Short questions are in the style of the new exam: answers should be between 0.5 and 1 page long and should include brief explanations of terms used, with diagrams/mathematics where necessary.

You should be prepared to offer and discuss answers to ALL other questions set in tutorial and so should make appropriate preparatory notes.

2nd Year Macroeconomics Tutorials, 2008-9Kate Doornik: kate.doornik@sbs.ox.ac.uk

Week 1 (Macroeconomics lectures 1 - 3):

This week we focus on equilibrium when all prices and wages are fully flexible (i.e., the medium run). In a closed economy, the equilibrium level of output and employment is fully determined by the supply side of the economy (in particular, by equilibrium in the labour market) and aggregate demand is irrelevant.

In a small, open economy, there is a range of output/employment levels that can form part of medium run equilibria, associated with different real exchange rates. The interest rate is equal to the world interest rate and so the real exchange rate adjusts to equate demand and supply. However, these medium run equilibria may be associated with trade imbalances that are not sustainable long term.

KEY TOPICS

Aggregate supply: labour market equilibriumo Equilibrium in competitive labour marketso Imperfect competition: wage setting and price setting curves o Voluntary vs. involuntary unemploymento The irrelevance of demand with flexible prices

Open economies with flexible priceso Different definitions of exchange rates, Purchasing Power Parityo Goods market equilibrium (ISXM/AD)*1

o Supply side: wage and price setting in open economy, ERU curveo Balance of trade, sustainability of imbalanceso Swan Diagram: short, medium and long run equilibrium.

NB: Real Business Cycles are also introduced in lectures this week, but we will not cover this topic in tutorials until after the Intertemporal Macroeconomics lectures.

READINGS (focus on the text book material first, before tackling other material)

Labour Market – wage and price setting Carlin and Soskice 2.5 – 2.7 (supply side in closed economy), 4.2 – 4.4 (more

detail on wage and price setting curves) Nickell (2003) “A Picture of European Unemployment: Success and Failure”

Centre for Economic Performance Discussion Paper (an applied analysis using this framework) http://cep.lse.ac.uk/pubs/download/dp0577.pdf

For the interested, an opposing view: Howell (2005) “Fighting Unemployment: Why labour market reforms are not the answer.” http://www.newschool.edu/cepa/publications_by_author.html#Howell

1 The curve that SWL lectures call ‘ISXM’ is labelled ‘AD’ in Carlin & Soskice

Open Economies Mankiw Ch 5 (Introductory level only : note that Mankiw assumes

output/employment fixed by supply side i.e., ERU vertical) Carlin & Soskice 9.1 (Goods market equilibrium), 9.4 (Balance of Trade), 10.2

(supply side, ERU curve), 10.3 (ISXM/AD curve, BT curve), 10.4, 10.5 (Swan Diagram: short, medium and long run equilibrium)

Krugman and Obstfeld, Chapter 15

Discussion of US deficit and global current account imbalances Carlin and Soskice 17.3.3 Mann (2002) “Perspectives on the U.S. Current Account Deficit and

Sustainability” Journal of Economic Perspectives 16(3): 131-152 Cooper (2008) “Global Imbalances: Globalization, Demography and

Sustainability.” Journal of Economic Perspectives 22(3): 93-112 Feldstein (2008) “Resolving the Global Imbalance: The Dollar and the U.S.

Saving Rate.” Journal of Economic Perspectives 22(3): 113-25

QUESTIONS

Short answer questions:1. (*) ‘The existence of involuntary unemployment depends on the presence of

imperfect competition in the labour market, but its level may also depend on imperfect competition in the goods market.” Explain this statement.

2. In imperfectly competitive goods and labour markets, what is the impact of a productivity increase on employment and real wages?

3. (*) Is Purchasing Power Parity compatible with a positive relationship between national output and competitiveness? (be careful about how ‘competitiveness’ is defined)

4. What is the relationship between the slopes of the BT and ISXM (or AD) curve in output/competitiveness space?

5. What determines the slope of the aggregate supply (ERU) curve in output/competitiveness space?

6. (*) Use the Swan diagram to analyse the impact of a country specific expansionary fiscal policy on the real exchange rate.

Essay/Discussion questions: 1. “Introducing imperfectly competitive goods and labour markets to the classical

macroeconomic model adds almost nothing to our understanding.” Discuss.2. Could innovations associated with the internet help explain the combination of a

strong dollar and a large current account deficit in the US in the first half of this decade?

2nd Year Macroeconomics Tutorials, 2008-9

Kate Doornik: kate.doornik@sbs.ox.ac.uk

Week 2 (Macroeconomics lectures 4 - 6):

This week we look at the behaviour of the economy in the short-run, when prices are ‘sticky’ and do not fully adjust to bring output back to ERU levels. This is the focus of Keynesian Economics. In the short run, the level aggregate demand determines the level of output and there is a role for monetary and fiscal policy to stabilize output. We look at the possible explanations for price rigidity given optimizing firms, emphasizing the important role of imperfect competition and whether small ‘menu costs’ could generate significant business cycles.

In the short run there is generally believed to be a trade-off between output levels and inflation. This is captured by short run Phillips curves, one for each level of current inflation. The 3 equation model combines the IS curve, short run Phillips curves and a ‘monetary rule’ curve to analyse the behaviour of central banks in using the interest rate to guide the economy back to a target rate of inflation at the ERU.

The traditional ‘backwards looking’ Phillips curve implies that agents repeatedly make mistakes in forming inflation expectations. Under rational expectations agents anticipate the new rate of inflation and, with a credible policy, there is no short run Phillips curve and disinflation is costless. New Keynesian theories of the Phillips curve use microfoundations of price formation to explain inflation inertia without irrationality.

KEY TOPICS

(New) Keynesian Economicso Implications of price rigidity: demand determines output, need for

stabilization policyo Microfoundations of price rigidity (imperfect competition, menu costs etc)o Recessions: 1930s, Japan 1990s, 2008 -??

Inflation o Costs of inflationo The (backwards looking) Phillips curveo Three equation model (IS curve/Phillips curve/Policy rule)o Demand and supply shocks and policy responses

Rational Expectations Revolutiono Disinflation with rational expectations, implications for ‘traditional’

backwards looking Phillips curveo The New Keynesian Phillips curve

READINGS (focus on the text book material first, before tackling other material)

Carlin and Soskice:

Review IS/LM analysis of Aggregate Demand (Carlin and Soskice 2.1-2.4, 2.7)

Traditional Phillips curve, rational expectations and costless deflation, monetary rules and the ‘3 equation model’, relation to ISLM (Carlin and Soskice Ch 3)

Costs of inflation and the optimal rate (Carlin and Soskice 5.1) New Keynesian Phillips Curve, microfoundations, role of imperfect competition

(Carlin and Soskice, Intro to Ch 15, 15.4, 15.6 - gets tricky) Japan in 1990s – Carlin and Soskice 17.4

Additional references from Mankiw (easier): Social costs of inflation, hyperinflation : Mankiw 4.6 and 4.7 Short run AS and the Phillips Curv: Mankiw Ch 13 New Keynesian Economics (microfoundations): Mankiw 19.2 The Great Depression (and Japan in 1990s): Mankiw 11.3

Recommended Further Reading (especially readings marked *): *Woodford, M (1999) “Revolution and Evolution in 20th Century

Macroeconomics” at http://www.columbia.edu/~mw2230 ( overview of history of thought in Macroeconomics, especially development of Keynesian Economics)

*Romer, D (1993) “The new Keynesian Synthesis” Journal of Economic Perspectives, 7 (1) pp5-22 (Keynesian microfoundations)

Krugman, P (2008) “The Return of Depression Economics and the Crisis of 2008” (The whole book is worth reading, and it’s quite a nice, quick read, but chapters on ‘Japan’s Trap’ and the two final chapters on current events are particularly relevant)

Botho, A and J Corbett (2000) “The assessment: Japan's stagnation - can policy revive the economy?”, Oxford Review of Economic Policy.

Sinclair, P (2003) “The optimal rate of inflation: an academic perspective” Bank of England Quarterly Bulletin 43(3) pp343 - 351

*Mankiw (2001) “The Inexorable and Mysterious Trade-Off between Inflation and Unemployment” Economic Journal, Conference Papers May, ppC45 – C61.

Stiglitz (1997) “Reflections on the Natural Rate Hypothesis” Journal of Economic Perspectives, 16(4) pp3-10.

QUESTIONS

Short answer questions:1. Explain why imperfect competition is central to the idea that short run output is

determined by aggregate demand2. If the expectations of wage setters are static, use the Phillips curve to analyse the

impact on output and inflation of a negative demand shock. What assumptions are you making about monetary policy?

3. Under what assumptions is disinflation costless? 4. If all prices were automatically indexed to the average price level, would inflation

no longer be a problem?

Essay/Discussion questions:

1. (*) How can something as small as menu costs be responsible for something as major as a recession?

2. Compare and contrast the traditional, backwards looking Phillips Curve with the New Keynesian Phillips curve?

3. Does recent experience suggest we have learned from the depressions of the 20th century?

2nd Year Macroeconomics Tutorials, 2008-9Kate Doornik: kate.doornik@sbs.ox.ac.uk

Week 3 (Macroeconomics lectures 7 & 9):

We will leave most of the content of lecture 8 (on money supply targeting etc) until next week.

KEY TOPICS Exchange rate dynamics: Uncovered Interest Parity, Dornbusch overshooting

model The open economy in the short run: Mundell Fleming Using the 3 equation model in the open economy – shocks and policy responses Fixed exchange rate regimes: costs and benefits, implications for policy

READING

Carlin and Soskice

9.2-9.3 (exchange rates: Uncovered Interest Parity, fixed and flexible regimes) 9.5 (Mundell-Fleming model, Dornbusch overshooting) Ch 11: (brings together the short and medium run models to look at effects of

various shocks in the open economy, plus policy responses.)

Additional textbook readings: Mankiw Ch 12 (but bear in mind limitations of LM approach) Krugman and Obstfeld (Ch13: p336 onwards on equilibrium exchange rates; Ch

17 on fixed exchange rate regimes)

Recommended Further Reading Rogoff (2002) “Dornbusch’s Overshooting Model after 25 Years” at

http://www.imf.org/external/pubs/ft/wp/2002/wp0239.pdf Dornbusch, R (2006) “The effectiveness of exchange rate changes” Oxford

Review of Economic Policy Vol 12 No 3 HM Treasury “UK Membership of the Single Currency: an assessment of the five

economic tests” 2003http://www.hm-treasury.gov.uk/euro_assess03_repindex.htm

QUESTIONS

Short Answer Questions:1. (*) Explain the economics behind Uncovered Interest Parity (UIP). Suppose UK

interest rates increased, but sterling depreciated in response. Could you explain this using UIP?

2. (*) Under a fixed exchange rate regime, what would be the impact on output and inflation of an increase in government spending?

3. When does UIP imply that domestic interest rates must equal overseas interest rates?

4. You have just heard that the central bank has unexpectedly announced a 1% increase in interest rates. What percentage change would you expect in the exchange rate, and why?

5. (*) During the period between the discovery of oil in the North Sea and its extraction, the UK current account moved sharply into deficit. Can you link these two events? What would you expect to have happened to the UK exchange rate over the same period?

6. Using algebra, demonstrate why fiscal policy will have no effect on output under flexible exchange rates if the monetary policies fix the money supply.

Essay/Discussion Questions

1. “If a government wants to reduce the rate of inflation using monetary policy, this will inevitably lead to overshooting of the exchange rate.” Do you agree? What are the implications for the use of fiscal policy?

2. “A floating exchange rate gives the monetary authority much greater influence over inflation.” “A floating exchange rate makes the monetary authority’s task much more difficult.” Are these statements contradictory?

Week 4 (mainly Macroeconomics lectures 10 and 11, but some references to earlier)

Monetary policy – especially inflation bias/time inconsistency

Costs of inflation, the ideal rate of inflation (review from earlier) Money supply targeting vs. interest rate reaction function (Monetary Rules) Derivation of Monetary Rules from central bank preferences, relation to Taylor

Rule Inflation bias (preferred y > ye)

o with short sighted policy maker and backwards looking Phillips curveo fully optimizing policy with rational expectations (= example of time

inconsistency problem) Problem of time inconsistency under rational expectations more generally e.g.,

stabilization bias Solutions to time inconsistency in practice: delegation, commitment, reputation,

transparency etc

READINGS

Carlin and Soskice Ch 5 Orphanides, A (2007) “Taylor Rules”

http://www.athanasiosorphanides.com/taylor22f.pdf Bernanke, B and Mishkin, F (1997) Inflation targeting: A New Framework for

Monetary Policy? On Kydland and Prescott’s work on time inconsistency (no need to read other

sections) http://nobelprize.org/nobel_prizes/economics/laureates/2004/ecoadv.pdf Clarida, Gali and Gertler (1999) “The Science of Monetary Policy: A New

Keynesian Perspective” Journal of Economic Literature 37 pp1661-1707 on stabilization bias.

Alesina, A. and Summers, L (1993) “Central bank independence and macroeconomic performance: some comparative evidence.” Journal of Money, Credit and Banking , Vol 25.

QUESTIONS

Short answer:1. What are the advantages and disadvantages of an inflation rate of 3%

compared to one of 0%? Could negative inflation be optimal? 2. Under what conditions is a Taylor rule the optimal Monetary Rule?3. If the monetary authorities use interest rates to target the money supply, how

does this compare with a monetary policy based on a Taylor Rule or Monetary Rule?

4. Under what circumstances might a central bank using an interest rate based monetary rule fail in its objective of raising output?

5. Is inflation bias the result of myopic governments or rational expectations?

Essay questions1. (*) Would policy makers better attain their macroeconomic objectives if they

had their discretion taken away from them? What does your conclusion imply for the argument that responsibility for monetary policy should be devolved to central banks?

2. “The time inconsistency problem only arises if the monetary policy has an unrealistic output target” Discuss

3. Is inflation the right target variable for monetary policy?4. Suppose the European Central Bank and the Federal Reserve Bank in the US

appear to follow a similar Taylor Rule. Does this imply they have similar objectives?

Week 5: Fiscal Policy (lecture 12)

Key Topics: Fiscal policy for short term stabilization

o When does it work?o When is it needed in addition to monetary policy?o Automatic stabilizers vs. discretionary policy

Deficits and debto Intertemporal budget constrainto Costs of rising debto Fiscal policy rules

SGP (EMU) UK Golden Rule

Reading Carlin and Soskice Ch 6 and 17.2.3 (if time, would recommend reading all of 17.1

and 17.2 on Europe) Wren-Lewis, S (2003) “Changing the Rules” New Economy Vol 10 (on home

page) Buiter, W (2003) “Ten Commandments for a Fiscal Rule in the E(M)U” Oxford

Review of Economic Policy 2003 19: 84-99 Allsop, C and D Vines (2005) “The Macroeconomic Role of Fiscal Policy”

Oxford Review of Economic Policy (other articles in this volumen of OxRep are also worth looking at)

Questions

Short answer:1. (*) ‘If a country has positive government debt, it must run a primary-budget

surplus’ Is this always true?2. What is a deficit bias, and why is it a problem?3. (*) What are automatic stabilizers, and why might they be preferable to

discretionary action?

Essay/Discussion questions1. (*) Why is a law the prescribed a balanced budget each period a bad idea? How

else do you prevent a steady increase in government debt? Short/outline answer only please

2. Does the EMU need a Fiscal Rule?3. 'When, if at all, should fiscal policy be used alongside monetary policy in the short term

stablisation of the economy'

Consumption (Chris Bowdler lectures 1-2)

Key Topics

The inter-temporal consumption problem Consumption Euler equations and the solved out consumption function Extensions: precautionary savings, habits, credit constraints Rational Expectations Permanent Income Hypothesis Excess sensitivity and excess smoothness Evidence on asset prices and consumption fluctuations

Reading

(*) Carlin and Soskice Ch 7.1

(*) J. Muellbauer, “The Assessment: Consumer Expenditure”, Oxford Review of Economic Policy, 1994, Summer.

Romer (2006) ‘Advanced Macroeconomics’ Ch 7 (can skip 7.5) - Slightly more advanced alternative to C&S with more detail on e.g., precautionary saving.

Deaton (1992) “Understanding Consumption” , Clarendon Lectures, OUP– very comprehensive reference, read selectively

Muellbauer (2007) “Housing, Credit and Consumption Expenditure” in Housing, Finance and Monetary Policy A Symposium sponsored by the Federal Reserve Bank of Kansas City, 2007 – survey of empirical work, particularly on effect of housing wealth.

Questions

Short answer1. Campbell (1987) uses the standard inter-temporal consumption model to argue

that increases in private saving predict future income reductions. (a) Will this prediction hold for both transitory and permanent income reductions? (b) Assuming perfect foresight, outline one reason for Campbell’s argument failing to hold in practice.

2. Suppose that utility (u) from consumption in any period t is given by u=ln(ct). (a) Using the consumption Euler equation, explain why Hall’s random walk result fails (b) How can the properties of logarithmic utility be used to explain the excess smoothness of consumption documented by Deaton (1987)

3. Early empirical studies of consumption demonstrated that the average propensity to consumer from income (APC) was lower amongst high income households than low income households, but relatively stable in aggregate as incomes rose over time. Can the theory of inter-temporal consumption account for this?

Essay/Discussion Questions

1. (*) “To call modern consumption theory a theory of “consumption” smoothing is a misnomer: it implies much more variability in the consumption data than more traditional theories.” Discuss.

2. Using the inter-temporal consumption model, discuss why interest rate reductions succeed in raising consumption in some cases but not others

Real Business Cycles : Bowdler Lecture 3; Wren-Lewis Lecture 2

Key Topics Stylized facts of business cycle fluctuations: amplitude, persistence, co-

movements RBC models: explaining fluctuations through random shocks to technology and

resulting inter-temporal substitution of labour and capital Labour supply and RBC theory Empirical calibration and assessment of RBC models: amplitude, persistence, co-

movements Plausibility of RBC story vs. (New) Keynesian explanations for business cycles

Reading

Mankiw 19.1 – a gentle introduction Carlin and Soskice (pp55-58) - just to see how RBC fits in with the overall story. (*) Romer Advanced Macroeconomics (2006) 4.1 – 4.5 and pp212-216. This is

the core theory for this week.

(*) Plosser, C (1989) “Understanding Real Business Cycles” Journal of Economic Perspectives 3(3), 51-77

(*) Mankiw (1989) “Real Business Cycles: A New Keynesian Perspective” Journal of Economic Perspectives 3 (3) 79-80. – for an opposing point of view.

(*) Muellbauer (1997) ‘The Assessment – Business Cycles’ Oxford Review of Economic Policy.

Ryan and Mullineux “The Ups and Downs of Modern Business Cycle Theory” in Snowdon and Vale (eds) Reflections on the Development of Modern Macroeconomics

Stadler, G (1994) “Real Business Cycles” Journal of Economic Literature.

Questions

Short answer

1. (*) Suppose a large, one-off productivity increase is expected in the next period. Use a standard RBC model to evaluate output, consumption and labour supply responses in the current period.

2. Compare the impact on the economy of a temporary productivity shock with a permanent productivity shock within an RBC framework,

3. Explain why the size of labour supply elasticity is crucial to the ability of RBC models to explain observed fluctuations in output.

4. (*) Can calibrated RBC models explain the amplitude and persistence of empirically observed fluctuations in output?

Essay5. (*) How much of the disagreement between Keynesian and RBC theory has to do

with differing views about what shocks hit the economy rather than how the economy reacts? Please submit an outline answer to this essay question

6. “The common observation that economic booms are associated with rising inflation causes problems for both RBC and New Keynesian theory” Discuss

7. Can the current recession be explained in RBC terms?8. Can RBC models be used to explain international business cycle co-movements?

Week 8, Economic Growth

Topics Neoclassical (Solow-Swan) Growth model: equilibrium, golden rule, effect of

changes in saving rate and population growth, “classical convergence”, exogenous technology growth in Solow model

Endogenous growth models1. AK model - assumption of constant returns)2. Romer model - Knowledge spillovers 3. Jones model – ‘semi-endogenous’ growth – ‘scale effects’ debate4. Schumpeterian (R&D) growth model

Convergence debate (this last topic will probably be too much to cover in reading and tutorial this week, but it would be advisable to study it yourself later if you want to full coverage of Growth )

Reading (*) Jones, C. “Introduction to Economic Growth” Chs 1-8 – this is the essential

reading on this topic, but you need to go a bit further to distinguish yourself

Other textbooks Barro and Salai-i-Martin “Economic Growth” gives a more advanced treatment

(Chs 1-7 and 12 are relevant) Greenhalgh and Rogers “Innovation, IP and Economic Growth” – Chs 8(&9 on

convergence debate) on course website Carlin and Soskice Chs 13-14 may also be helpful. 13.5 is relevant to

convergence debate.

Additional Reading Jones (1999) “Growth: With or Without Scale Effects?” AER 89(2):139-44 Rogers (2003) “A Survey of Economic Growth” Economic Record 79 (244) Collier, P. (2007) “The bottom billion: Why the poorest countries are failing

and what can be done about it” Oxford (on convergence debate)

Questions

Short Answer1. Explain the Golden Rule in a Solow-Swan model with exogenous savings. Does

the concept still apply if savings are endogenous? Is it more realistic to assume exogenous or endogenous savings?

2. An economy is at steady state in the Solow-Swan model. Discuss the short and long run implications of i) a rise in population growth ii) a fall in depreciation

3. Using the Solow-Swan model, explain how taxation might affect steady state outcomes. Can taxation affect growth rates?

4. Explain why “scale effects” are important in endogenous growth models5. Compare and contrast Paul Romer’s and Charles Jones’ R&D growth models.

Essays1. (*) How far can the shortcomings of the Solow neoclassical growth model be

overcome by alternative models of economic growth?2. “R&D based models of economic growth are appealing in theory, but are rarely

useful in practice.” Discuss3. Do endogenous growth models suggest there is a role for policy in achieving the

optimal growth rate?4. (Can growth theory help understand the dispersion of GDP per capital across

countries?)