Lecture 1 Modern Macroeconomics - Lakehead Universityflash.lakeheadu.ca/~kyu/E5118/M1.pdf · Outcomes: market price and quantity of the exchanges Entrepreneurs: enterprising persons

Lecture 1 Modern MacroeconomicsEconomics 5118 Macroeconomic Theory

Kam Yu

Winter 2013

Outline

1 Historical Facts

2 Macroeconomic Theory

3 Looking Ahead

4 What’s in for Me?

5 Dynamical Systems

6 Recap: The Nature of EconomicsThe Market EconomyThe Economist

7 Further Readings

Kam Yu (LU) Lecture 1 Modern Macroeconomics Winter 2013 2 / 26

Historical Facts

Ancient History

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Figure !.! World economic history in one picture. Incomes rose sharply in many countries after 1800 but declined in others.

typical English worker of 1800, even though the English table by then included such exotics as tea, pepper, and sugar.

And hunter-gatherer societies are egalitarian. Material consumption varies little across the members. In contrast, inequality was pervasive in the agrarian economies that dominated the world in 1800. The riches of a few dwarfed the pinched allocations of the masses. Jane Austen may have written about re-fined conversations over tea served in china cups. But for the majority of the English as late as 1813 conditions were no better than for their naked ancestors of the African savannah. The Darcys were few, the poor plentiful.

So, even according to the broadest measures of material life, average welfare, if anything, declined from the Stone Age to 1800. The poor of 1800, those who lived by their unskilled labor alone, would have been better off if transferred to a hunter-gatherer band.

The Industrial Revolution, a mere two hundred years ago, changed for-ever the possibilities for material consumption. Incomes per person began to undergo sustained growth in a favored group of countries. The richest mod-ern economies are now ten to twenty times wealthier than the 1800 average. Moreover the biggest beneficiary of the Industrial Revolution has so far been

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Source: Gregory Clark (2007) A Farewell to Alms: A Brief Economic History of the World,

Princeton University Press.


Historical Facts

Recent History (Canada)


Historical Facts

The Great Recession of 2008


Macroeconomic Theory

Early Writings

David Hume (1752) “Of Money” — Short-run and long-run effects ofmonetary injections

Knut Wicksell (1898) “Interest and Prices” — Difference betweenrate of return on capital and interest rate on bonds

Irving Fisher (1911) “The Purchasing Power of Money” — Quantitytheory of money

MV = PY

Frank Ramsey (1928) “A Mathematical Theory of Saving” — Basicmodel in growth theory



Keynesian Revolution

John Maynard Keynes (1936) “The General Theory of Employment,Interest, and Money” — A reaction to the Great Depression

John Hicks (1937) — IS-LM model1 IS — linking financial market with components of output and fiscal

policy2 LM — balance supply and demand of money given price level

A.W. Phillips (1958) — “The Relation Between Unemployment andthe Rate of Change of Money Wage Rates in the United Kingdom,1861–1957”



The Phillips Curve



The Monetarists

Milton Friedman and Ana Schwartz (1963) “A Monetary History ofthe United States, 1867–1960” — Economic instability is a result ofinept monetary policy

The impact of a monetary shock has a long and unknown effect onthe economy (about 4 years)

The long-run inflation-employment trade-off is an illusion (Phelps,1968)

In the long-run money is neutral



New Classical Economics

Emphasize rational expectations (Lucas, 1973; 1976)

Monetary policy works only because of imperfect information

In the long-run monetary policy cannot be used to stabilize theeconomy (surprises have limits)

Lucas critique: Decision rules for investment, consumption, andexpectations formation will not be invariant to shifts in the systematicbehaviour of policy



Real Business Cycle

Kydland and Prescott (1982)

Walrasian dynamic general equilibrium — markets always clear

Agents are forward looking and optimize intertemporal welfare(present and future)

Expectations about the future may shift according to the economicenvironment

Monetary policy is irrelevant

Economic fluctuations come from technological shocks (innovations)

Parameters of the model are calibrated

Resulting dynamic responses, variances, and covariances amongvariables are compared with actual data



The New Keynesians

The old Keynesian model assumes complete price rigidity (a veryshort-run model) and deals with the demand side only

Classical economics emphasizes the invisible hand of free market(markets clear eventually, and prices are endogenous)

What happen in between?

Some markets (goods and labour) take time to clear: institutionalfriction, staggering wage contracts, market power, transaction costs(searching, matching, training, imperfect information, efficiencywage), . . .

Monetary policy can be a useful tool to stabilize the economy in theshort-run.



Effects of a 0.1% Negative Monetary ShockBen S. Bernanke and Mark Gertler 31

Figure I

Responses of Output, Prices and Federal Funds Rate to a Monetary Policy Shock

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0.006 - - - GDP Deflator /I\ - - Funds Rate

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inflation.7 The figure shows the estimated dynamic responses of log real GDP, the log

of the GDP deflator and the funds rate to a positive, one-standard-deviation shock to the

funds rate (which we interpret as an unanticipated tightening of monetary policy). As

output and prices are measured in logs, the responses can be interpreted as proportions

(that is, .001 = 0.1 percent) of baseline levels.

According to the estimated response patterns shown in Figure 1, GDP begins

to decline about four months after a tightening of monetary policy, bottoming out

about two years after the shock. The price level remains inert for about a year, then

begins to decline, well after the drop in GDP begins. (The commodity price index,

not shown, drops more quickly.) Finally, after rising sharply initially, the funds rate

begins to fall precipitously after three to four months. Nine to 12 months after the

policy innovation, the deviation of the funds rate from its baseline path is only a

quarter or less of the initial shock; at two years out, the funds rate is essentially back

to trend. These patterns are summarized above as Fact 1. These results in monthly

data are quite consistent with the patterns observed by others in quarterly data and

for various shorter sample periods. Although we do not show standard error bands

in the figures, these responses and all that we report subsequently are statistically

significant at conventional levels.

7 Sims (1992) and Christiano, Eichenbaum and Evans (1994b) discuss in detail the rationale for including the index of commodity prices; see also Sims and Zha (1993). Inclusion of this variable, along with measures of output and the general price level, has become conventional in the recent VAR-based literature on monetary policy.

Source: Bernanke and Gertler (1995)



The New Synthesis

Take market imperfections from New Keynesian models and put themin a RBC model

New name: Dynamic stochastic general equilibrium (DSGE) model

What imperfections?1 Unemployment and the labour market — structural unemployment,

intertemporal substitution, unemployment benefits, union power,efficiency wage, . . .

2 Credit channels — Looking inside the blackbox: how do monetaryshocks go through the system? How do firms finance their investmentin the asset market?

3 Increasing returns — oligopolistic firms, counter-cyclical mark-up,multiple equilibria, . . .

4 Are agents’ expectations really rational? — bounded rationality,herding effect, imperfect arbitrage, animal spirits, asset bubbles, . . .


Looking Ahead

What’s next?

More imperfections?

Heterogenous agents

Putting the financial sector in the system

Policy and welfare — leisure and productivity, creative destructionsped up by recession, education and health care, . . .

Short, medium, or the long run?

It’s the institutions stupid!

Big models eating up small models

Measurement issues: capital, knowledge, productivity

Deja vu — DSGE theory is all math, no economics!


What’s in for Me?

Are you a scientist or an engineer?

In this course we hope to learn

1 The basic ingredients of the dynamic general equilibrium models

2 Basic growth models

3 The first decentralized DGE model

4 Public finance: taxes, debt, or printing money

5 Market imperfections and price dynamics

6 The monetary economy

7 Monetary policy


Dynamical Systems

An Idealized Economy

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Dynamical Systems

Detrended with a Filter

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Dynamical Systems

Other Dynamical Systems

In reality, an economy has tens of thousands of firms and millions of households,

each has its own dynamics.


Dynamical Systems

Other Dynamical Systems

In reality, an economy has tens of thousands of firms and millions of households,

each has its own dynamics.


Dynamical Systems

Business Cycles—The U.S. Experience


Recap: The Nature of Economics The Market Economy

How Economists See the World



Ingredients of a Market

Buyers

Sellers

Voluntary exchanges

Terms and conditions of the contract

Outcomes: market price and quantity of the exchanges

Entrepreneurs: enterprising persons who discover and exploreprofitable opportunities and organize and manage production ventures

Assumption: all parties behave in their self interests.



The Economic Problem

Two facts:

1 Resources such as capital, labour, energy, land, and talent are in limitsupply (scarcity)

2 People always want more than what they have

Problems to be resolved:

1 What will be produced?

2 How will things be produced?

3 Who get what?

4 Who make these decisions?


Recap: The Nature of Economics The Economist

What Do Economists Do?

Social scientist — study and explain how society resolve the economicproblem by looking at people’s incentives and behaviours undervarious constraints.

Policy analyst — Design and analysis of how government policies andregulations to achieve efficiency.

Business consultant and advisor — Translate an organization’sproblem into an economic model, find the best solution, and translatethe results back into business actions and strategies.


Recap: The Nature of Economics The Economist

Tools that Economists Use

Economic theory or models — A model is an abstract representationof reality. Examples are

a highway mapa electrical circuit diagraman organization charta formal mathematical systema prototype

Empirical analysis — collecting raw data, data construction, andstatistical analysis.

Forecasting — Combining theoretical and empirical analysis to predictthe future.


Further Readings

References

Blanchard, Olivier (2000) “What do we know about macroeconomics that Fisherand Wicksell did not?” Quarterly Journal of Economics, 115(4), 1375–1409.

Chari, V. V. and Patrick J. Kehoe (2006) “Modern Macroeconomics in Practice:How Theory Is Shaping Policy,” Journal of Economic Perspectives, 20(4),3–28.

Mankiw, N. Gregory (2006) “The Macroeconomist as Scientist and Engineer,”Journal of Economic Perspectives, 20(4), 29–46.

Woodford, Michael (2009) “Convergence in Macroeconomics: Elements of theNew Synthesis,” American Economic Journal: Macroeconomics, 1(1),267–279.


Documents

Lecture 1 Modern Macroeconomics - Lakehead Universityflash.lakeheadu.ca/~kyu/E5118/M1.pdf · Outcomes: market price and quantity of the exchanges Entrepreneurs: enterprising persons