Macroeconomics III - Introductionhomepage.ntu.edu.tw/~sschen/temp/2012_Lecture_0_introduction.pdf · the IS-LM model) dominated macroeconomics for some 25 years (1945–1970). However,

Macroeconomics III

Introduction

Shiu-Sheng Chen

Department of Economics

National Taiwan University

January 30, 2013

Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, 2013 1 / 39

Macroeconomics: An Overview

The Story of Macroeconomics

Modern Macroeconomic Theory and Its Evolution from Conceptual

and Methodology Perspectives


The Evolution of Macroeconomic Theory

The history of modern macroeconomics starts in 1936, with the

publication of Keynes’s General Theory of Employment, Interest and

Money.

Background: The Great Depression (1930s)

John Maynard Keynes (1883–1946)



The Main Keynesian Ideas

Income Determination

◮ Effective Demand (Aggregate Demand): involuntary unemployment

resulted from a deficiency in aggregate demand.

◮ Consumption vs. Disposable Income

◮ Multiplier

Monetary Policy

◮ Liquidity Preference (money vs. interest rate)

Expectations

◮ Animal Spirits



The Development of Macroeconomics in 1950s

Neoclassical Synthesis (IS-LM Model)

Theory of Consumption, Investment, and Money Demand

Growth Theory (Solow model)

Macroeconometric Models


Development of Macroeconomics in 1950s

Neoclassical Synthesis (IS-LM Model)

A model with goods and financial markets

Sir John Richard Hicks (1904–1989), Oxford. Nobel Laureate (1972)

Paul A. Samuelson (1915–2009), MIT. Nobel Laureate (1970)



Consumption Theory: The Permanent Income Hypothesis

Franco Modigliani (1918–2003), MIT. Nobel Laureate (1985)

Milton Friedman (1912–2006), Chicago. Nobel Laureate (1976)



Investment Theory and Theory of the Demand for Money

James Tobin (1918–2002), MIT. Nobel Laureate (1981)

Tobin’s q = market valuereplacement cost

Tobin-Baumol inventory model of money demand

Tobin Tax



Neo-Classical Growth Model

Robert M. Solow (1924–), MIT. Nobel Laureate (1987)



Large-scale Macroeconometric Models

Lawrence R. Klein (1920–), UPenn. Nobel Laureate (1980)




Keynesians believe that

◮ The nature of fluctuations was becoming increasingly well understood.

◮ The models allowed policy decisions to be made more efficiently.

◮ The Phillips curve: the trade-off.

◮ The economy could be fine-tuned, and there is possibility that

recessions can be eliminated.

Keynesians vs. Monetarists

◮ Monetary Policy vs. Fiscal Policy

◮ The Phillips Curve

◮ The Role of Policy



Keynesians vs. Monetarists



Monetary Policy vs. Fiscal Policy

Keynesian:

◮ To fight recessions, fiscal policy could affect output faster and more

reliable, and monetary policy did not work well.

Monetarist:

◮ Monetary policy was very powerful.

◮ The movements in money explained most of the fluctuations in output.



The Phillips Curve

Keynesian:

◮ There exists trade-off between unemployment and inflation, even in the

long run.

◮ Why? Money illusion.

Monetarist:

◮ After accounting for expectations, no such trade-off exists in the

long-run. People won’t be fooled in the long-run.

◮ The unemployment rate could not be substained below a certain level,

which is called “natural rate of unemployment” by Milton Friedman

and Edmund Phelps.



The Phillips Curve

Edmund Strother Phelps, Jr. (1933–), Columbia. Nobel Laureate

(2006)



The Role of Policy

Rules vs. Discretion

For example,

a steady money growth vs. political pressure to “do something”




Despite the criticisms from the monetarists, the Keynesians (mainly

the IS-LM model) dominated macroeconomics for some 25 years

(1945–1970).

However, some economists were nonetheless of the opinion that

macroeconomics needed a stronger microfoundational anchor.

◮ microfoundations: an optimization model of households and firms.

◮ This indeed has been done in growth models (Ramsey-Cass-Koopmans

neoclassical growth model), but such model was deterministic, and not

used for discussing business cycles.

◮ Ramsey (1928); Cass (1965); Koopmans (1965)



Frank P. Ramsey (1903–1930)

David Cass (1937–2008)

Tjalling Koopmans (1910–1985), Nobel Laureate (1975)




A new approach with microfoundation emerges: the disequilibrium

(non-Walrasian equilibrium) modelling

However, there was a more important development in

macroeconomics: the new classical macroeconomics.

◮ rational expectations

◮ microfoundation

The Rational Expectations Revolution

◮ Implications

◮ Applications



The Rational Expectations Revolution

Background: Stagflation in mid-1970s

Robert Lucas, Jr. (1937–), Chicago. Nobel Laureate (1995)

Thomas J. Sargent (1943–), NYU. Nobel Laureate (2011)

Robert J. Barro (1944–), Harvard.


Rational Expectations

Definition

People optimally use all the available information to forecast the

future.

Implications

Lucas Critique

Rational Expectations and the Phillips Curve

Applications

On Macroeconomics and Finance

On Wage and Price Setting

On Theory of Policy


Implications of Rational Expectations

Lucas Critique

Given a structure model

yt = c

∞∑

j=0

bjEtxt+j

The reduced-form representation

yt =c

1− bφxt

depends on the process for xt with the form xt = φxt−1 + εt.

Hence, the reduced-form econometric model based on historical data

(t = 1, 2, . . . , T )

yt = βxt

is useless for policy analysis (say, regime changes from φ to θ at time

T + 1).


Implications of Rational Expectations

Rational Expectations and the Phillips Curve

Using the Keynesian framework, Lucas show that money does not

have long-lasting effects on output under rational expectation.

Only unanticipated changes in money should affect output.


Applications of Rational Expectations

Macroeconomics and Finance

Rational expectation became the mainstream assumption in 1970s

and 1980s.

There was a wide applications of rational expectations in

◮ Macroeconomics: Random walk of consumption (Robert Hall, 1943–,

Stanford)

◮ Financial economics: Overshooting model of the exchange rate (Rudi

Dornbusch, 1942–2002, MIT)



Wage and Price Setting

Sticky wage and sticky price under rational expectation

Stanley Fisher (1943–, Bank of Israel)

John Taylor (1946–, Stanford)



The Theory of Policy

The forward-looking behavior (i.e., rational expectation) by people and

firm leads to the following notions when discussing policy

Credibility

Reputation

Commitment


Recent Developments in Macroeconomics

New Classical Macroeconomics and Real Business Cycle Theory

New Keynesian Macroeconomics

New Growth Theory

Toward an Integration: DSGE Models




New Classicals/RBC

Edward C. Prescott (1940–,), Arizona State. Nobel Laureate (2004)




Main Contributions of the New Classicals:

Methodological:

◮ Incooperating random shock into the neoclassical optimizing growth

model◮ Numerical analysis with aid of the computer technology: calibration

⋆ Move from the model to the data (facts)

⋆ Moment matching

Conceptual:

◮ Technology shocks matter and dominate.

◮ Competitive market with fully flexible prices and wages




William A. Brock (Wisconsin)

You would see random movements in capital and consumption, et cetera.

And maybe that would look like something bad, but it’s a competitive

equilibrium, so it’s Pareto optimal; you can’t beat it.

Brock and Mirman (1972) =⇒ Kydland and Prescott (1982)




In general, the New Keynesians accept the rational expectation

assumption but still emphasize the importance of imperfections

(frictions) in different markets.

The New Keynesians share the belief that those imperfections play a

role in macroeconomic fluctuations.




Market frictions

◮ Labor markets: efficiency wages (George Akerlof, Berkeley. Nobel

Laureate (2001))

◮ Credit markets (Ben Bernanke, Princeton, Fed)

◮ Goods markets: menu cost (Gregory Mankiw, Harvard)



New Growth Theory

Growth theory was active in 1960s. It went into intellectual slump in 1970-1980s.

In the late 1980s, the growth theory struck back.

Leaders: Paul Romer, NYU and Robert Lucas

◮ Endogenous growth theory (IRTS, R&D, human capital)

David Warsh (2006) Knowledge and the Wealth of Nations: A Story of Economic

Discovery, W. W. Norton [知識與國富論: 一個探索經濟成長的故事 (時報文化)]



New Growth Theory

Creative destruction:

Philippe Aghion (Harvard, French) and Peter Howitt (Brown, Canadian)

Legal system: Andrei Shleifer (Harvard, Russian American)

Institutions: Daron Acemoglu (MIT, Turkish-American)



Toward an Integration?

In the 1980-1990s, there were big fights between new classicals and

new Keynesians.

New Keynesians accuse new classicals of◮ relying on an implausible explanation of fluctuations

◮ ignoring obvious imperfections

New classicals complains about the ad hoc nature of most of the new

Keynesian models.

Toward a convergence?◮ RBC approach (microfoundations )

◮ Keynesian elements: imperfections (frictions) in the labor, financial,

and goods markets.

The integrated models are now called dynamic stochastic general

equilibrium (DSGE) models



DSGE Models

Utility and profit maximization

Rational expectations

Nominal rigidity

◮ Keynesian element?



DSGE Models

A quote from a prominent new Keynesian economist

◮ The New Keynesian model has become the workhorse for the analysis

of monetary policy, fluctuations, and welfare (Gali, 2008).

John Taylor “What Does Anti-Keynesian Mean? ”

◮ In my view, rigidities exist in the real world and to describe accurately

how the world works you need to incorporate such rigidities in your

models, which of course Keynes emphasized. But you also need to

include forward-looking expectations, incentives, and growth

effects–which Keynes usually ignored.

◮ In my view the essence of the Keynesian approach to macro policy is

the use by government officials of discretionary countercyclical actions

and interventions to prevent or mitigate recessions or to speed up

recoveries.



DSGE Models

Calibration

Estimation (Baynesian Estimation)

Forecasting


Why Studying Monetary Economics?

Evidence suggests that money plays an important role in generating

business cycles

Recessions (unemployment) and expansions affect all of us

Monetary Theory ties changes in the money supply to changes in

aggregate economic activity and the price level

In particular, the 2008-2009 financial crisis has revealed the

importance of understanding money, banking, and financial markets.


Documents

Macroeconomics III - Introductionhomepage.ntu.edu.tw/~sschen/temp/2012_Lecture_0_introduction.pdf · the IS-LM model) dominated macroeconomics for some 25 years (1945–1970). However,