Macroeconomics III. Introduction. Shiu-Sheng Chen. Department of Economics National Taiwan University. January 30, 2013
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1 Macroeconomics III Introduction Shiu-Sheng Chen Department of Economics National Taiwan University January 30, 2013 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
2 Macroeconomics: An Overview The Story of Macroeconomics Modern Macroeconomic Theory and Its Evolution from Conceptual and Methodology Perspectives Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
3 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 ( ) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
4 The Evolution of Macroeconomic Theory 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 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
5 The Evolution of Macroeconomic Theory The Development of Macroeconomics in 1950s Neoclassical Synthesis (IS-LM Model) Theory of Consumption, Investment, and Money Demand Growth Theory (Solow model) Macroeconometric Models Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
6 Development of Macroeconomics in 1950s Neoclassical Synthesis (IS-LM Model) A model with goods and financial markets Sir John Richard Hicks ( ), Oxford. Nobel Laureate (1972) Paul A. Samuelson ( ), MIT. Nobel Laureate (1970) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
7 Development of Macroeconomics in 1950s Consumption Theory: The Permanent Income Hypothesis Franco Modigliani ( ), MIT. Nobel Laureate (1985) Milton Friedman ( ), Chicago. Nobel Laureate (1976) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
8 Development of Macroeconomics in 1950s Investment Theory and Theory of the Demand for Money James Tobin ( ), MIT. Nobel Laureate (1981) Tobin s q = market value replacement cost Tobin-Baumol inventory model of money demand Tobin Tax Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
9 Development of Macroeconomics in 1950s Neo-Classical Growth Model Robert M. Solow (1924 ), MIT. Nobel Laureate (1987) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
10 Development of Macroeconomics in 1950s Large-scale Macroeconometric Models Lawrence R. Klein (1920 ), UPenn. Nobel Laureate (1980) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
11 The Evolution of Macroeconomic Theory The Development of Macroeconomics in 1960s 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 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
12 The Evolution of Macroeconomic Theory Keynesians vs. Monetarists Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
13 The Development of Macroeconomics in 1960s 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. Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
14 The Development of Macroeconomics in 1960s 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. Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
15 The Development of Macroeconomics in 1960s The Phillips Curve Edmund Strother Phelps, Jr. (1933 ), Columbia. Nobel Laureate (2006) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
16 The Development of Macroeconomics in 1960s The Role of Policy Rules vs. Discretion For example, a steady money growth vs. political pressure to do something Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
17 The Evolution of Macroeconomic Theory The Development of Macroeconomics in 1970s Despite the criticisms from the monetarists, the Keynesians (mainly the IS-LM model) dominated macroeconomics for some 25 years ( ). 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) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
18 The Evolution of Macroeconomic Theory Frank P. Ramsey ( ) David Cass ( ) Tjalling Koopmans ( ), Nobel Laureate (1975) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
19 The Evolution of Macroeconomic Theory The Development of Macroeconomics in 1970s 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 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
20 The Development of Macroeconomics in 1970s 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. Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
21 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 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
22 Implications of Rational Expectations Lucas Critique Given a structure model y t = c The reduced-form representation y t = b j E t x t+j j=0 c 1 bφ x t depends on the process for x t with the form x t = φx t 1 +ε t. Hence, the reduced-form econometric model based on historical data (t = 1,2,...,T) ŷ t = ˆβx t is useless for policy analysis (say, regime changes from φ to θ at time T +1). Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
23 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. Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
24 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, , MIT) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
25 Applications of Rational Expectations Wage and Price Setting Sticky wage and sticky price under rational expectation Stanley Fisher (1943, Bank of Israel) John Taylor (1946, Stanford) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
26 Applications of Rational Expectations 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 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
27 Recent Developments in Macroeconomics New Classical Macroeconomics and Real Business Cycle Theory New Keynesian Macroeconomics New Growth Theory Toward an Integration: DSGE Models Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
28 Recent Developments in Macroeconomics New Classical Macroeconomics and Real Business Cycle Theory New Classicals/RBC Edward C. Prescott (1940,), Arizona State. Nobel Laureate (2004) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
29 Recent Developments in Macroeconomics New Classical Macroeconomics and Real Business Cycle Theory 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 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
30 Recent Developments in Macroeconomics New Classical Macroeconomics and Real Business Cycle Theory 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) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
31 Recent Developments in Macroeconomics New Keynesian Macroeconomics 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. Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
32 Recent Developments in Macroeconomics New Keynesian Macroeconomics 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) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
33 Recent Developments in Macroeconomics New Growth Theory Growth theory was active in 1960s. It went into intellectual slump in s. 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 )] Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
34 Recent Developments in Macroeconomics New Growth Theory Creative destruction: Philippe Aghion (Harvard, French) and Peter Howitt (Brown, Canadian) Legal system: Andrei Shleifer (Harvard, Russian American) Institutions: Daron Acemoğlu (MIT, Turkish-American) Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
35 Recent Developments in Macroeconomics Toward an Integration? In the s, 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 Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
36 Recent Developments in Macroeconomics DSGE Models Utility and profit maximization Rational expectations Nominal rigidity Keynesian element? Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
37 Recent Developments in Macroeconomics 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. Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
38 Recent Developments in Macroeconomics DSGE Models Calibration Estimation (Baynesian Estimation) Forecasting Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
39 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 financial crisis has revealed the importance of understanding money, banking, and financial markets. Shiu-Sheng Chen (NTU Econ) Macroeconomics III January 30, / 39
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