Lecture Notes in Macroeconomics. Christian Groth
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1 Lecture Notes in Macroeconomics Christian Groth July 28, 2016
2 ii
3 Contents Preface xvii I THE FIELD AND BASIC CATEGORIES 1 1 Introduction Macroeconomics The field The different runs Components of macroeconomic models Basics The time dimension of input and output Macroeconomic models and national income accounting Some terminological points Brief history of macroeconomics Literature notes Review of technology and firms The production technology A neoclassical production function Returns to scale Properties of the production function under CRS Technological change The concepts of a representative firm and an aggregate production function The neoclassical competitive one-sector setup Profit maximization Clearing in factor markets More complex model structures* Convex capital installation costs Long-run vs. short-run production functions iii
4 iv CONTENTS A simple portrayal of price-making firms The financing of firms operations Literature notes Appendix Exercises II LOOKING AT THE LONG RUN 63 3 The basic OLG model: Diamond Motives for saving The model framework The saving by the young Production The dynamic path of the economy Technically feasible paths A temporary equilibrium An equilibrium path The golden rule and dynamic ineffi ciency Concluding remarks Literature notes Appendix Exercises A growing economy Harrod-neutrality and Kaldor s stylized facts The Diamond OLG model with Harrod-neutral technological progress The golden rule under Harrod-neutral technological progress The functional distribution of income The CES production function* Concluding remarks Literature notes and discussion Appendix Exercises Applying and extending the Diamond model Pension schemes and aggregate saving Endogenous labor supply The intensive margin: A simple one-period model Endogenous labor supply in an extended Diamond model Early retirement with transfer income
5 CONTENTS v 5.4 Intertemporal substitution of labor supply Literature notes Appendix: The extended Slutsky equation Long-run aspects of fiscal policy and public debt An overview of government spending and financing issues The government budget Government solvency and fiscal sustainability The critical role of the growth-corrected interest factor Sustainable fiscal policy Debt arithmetic The required primary budget surplus Case study: The Stability and Growth Pact of the EMU Solvency, the NPG condition, and the intertemporal government budget constraint When is the NPG condition necessary for solvency? Equivalence of NPG and GIBC A proper accounting of public investment* Ricardian equivalence? Two differing views A small open OLG economy with a temporary budget deficit Concluding remarks Literature notes Exercises Bequests and the modified golden rule Bequests Barro s dynasty model A forward-looking altruistic parent Case 1: the bequest motive operative (b t+1 > 0 optimal) Case 2: the bequest motive not operative (b t+1 = 0 optimal) Necessary and suffi cient conditions for the bequest motive to be operative Bequests and Ricardian equivalence The modified golden rule when there is technological progress* Concluding remarks Literature notes Appendix Exercises
6 vi CONTENTS 8 Optimal capital accumulation Command optimum A social planner The modified golden rule of the command optimum The turnpike property Optimal control theory and the social planner s problem* Decomposing the social planner s problem Applying the Maximum Principle The overtaking and catching-up criteria* Concluding remarks Literature notes Appendix Exercises The intertemporal consumption-saving problem in discrete and continuous time Market conditions Maximizing discounted utility in discrete time Transition to continuous time analysis Maximizing discounted utility in continuous time The saving problem in continuous time Solving the saving problem The Keynes-Ramsey rule Mangasarian s suffi cient conditions The consumption function Concluding remarks Literature notes Appendix Exercises The basic representative agent model: Ramsey Preliminaries The agents Households Firms General equilibrium and dynamics Comparative analysis The role of key parameters Solow s growth model as a special case A social planner s problem The equivalence theorem
7 CONTENTS vii Ramsey s original zero discount rate and the overtaking criterion* Concluding remarks Literature notes Appendix Exercises Applications of the Ramsey model Market economy with a public sector Public consumption financed by lump-sum taxes Income taxation Effects of shifts in the capital income tax rate Ricardian equivalence Learning by investing and investment-enhancing policy The common framework The arrow case: λ < Romer s limiting case: λ = 1, n = Concluding remarks Literature notes Appendix Exercises Overlapping generations in continuous time Introduction The model of perpetual youth Households Aggregation The representative firm General equilibrium (closed economy) Adding retirement The rate of return in the long run National wealth and foreign debt Concluding remarks Literature notes Appendix Exercises General equilibrium analysis of public and foreign debt Reconsidering the issue of Ricardian equivalence Dynamic general equilibrium effects of lasting budget deficits Public and foreign debt: a small open economy
8 viii CONTENTS 13.4 Government debt when taxes are distortionary* Public debt policy Credibility problems due to time inconsistency Literature notes Appendix Exercises III MODELING FIXED CAPITAL INVESTMENT Fixed capital investment and Tobin s q Convex capital installation costs The decision problem of the firm The implied investment function A not implausible special case Marginal q and average q Applications Concluding remarks Literature notes Appendix Exercises Further applications of adjustment cost theory Oil price shock in a small oil importing economy Three inputs: capital, labor, and raw material General equilibrium and dynamics National income accounting for an open economy with capital installation costs Household behavior and financial wealth General aspects of modeling a small open economy Housing and the macroeconomy The housing service market and the house market Construction activity Equilibrium dynamics Discussion Literature notes Appendix Exercises
9 CONTENTS ix IV MODELING MONEY Money in macroeconomics What is money? The concept of money Historical remarks The functions of money The money supply Different measures of the money stock The money multiplier Money demand What is then the money market? Key questions in monetary theory and policy Literature notes Exercises Inflation and capital accumulation: The Sidrauski model The agents Equilibrium and evolution over time Theoretical implications Money neutrality and superneutrality Milton Friedman s zero interest rate rule Discussion Are inflation and deflation bubbles possible? Concluding remarks Literature notes Appendix Exercises Wider perspectives on monetary economies Money growth and inflation in the long run Are neutrality and superneutrality of money theoretically robust properties? Inflationary public finance The seigniorage Laffer curve Hyperinflation Bridging the gap between the short and the long run The monetary transmission mechanism in the short and the long run Inflation - social costs and benefits A glimpse of theory of the level of interest rates
10 x CONTENTS 18.6 Literature notes Appendix Exercises V LOOKING AT THE SHORT RUN The theory of effective demand Stylized facts about the short run A simple short-run model Elements of the model The case of fully flexible W and P The case of W and P fixed in the short run Short-run adjustment dynamics Price setting and menu costs Imperfect competition with price setters Price adjustment costs Menu costs in action Abundant capacity Putty-clay technology Capacity utilization and monopolistic-competitive equilibrium Aggregation over different regimes* Concluding remarks Literature notes Appendix Exercises General equilibrium under monopolistic competition The emergence of new-keynesian economics The Blanchard-Kiyotaki model of monopolistic competition Overview of agents decision problems The resulting behavior General equilibrium The case with flexible wages and prices The case with sticky wages and prices Spillover complementarity and multiple equilibria Concluding remarks Literature notes Appendix Exercises
11 CONTENTS xi 21 The IS-LM model The building blocks The output market Asset markets Keynesian equilibrium Alternative monetary policy regimes Money stock rule Fixed interest rate rule Counter-cyclical interest rate rule Further aspects Some robustness checks Presence of an interest rate spread (banks lending rate = i + ω > i) What if households are infinitely-lived? Concluding remarks Literature notes Appendix Exercises IS-LM dynamics with forward-looking expectations A dynamic IS-LM model Monetary policy regimes Policy regime m: Money stock rule Policy regime i: Fixed short-term interest rate Policy regime i : A counter-cyclical interest rate rule Discussion Literature notes Appendix The open economy and alternative exchange rate regimes The Mundell-Fleming model The basic elements Fixed exchange rate Floating exchange rate Perspectives Dynamics under a fixed exchange rate Dynamics under a floating exchange rate: overshooting The model Unanticipated rise in the real money supply Anticipated rise in the money supply Monetary policy tightening
12 xii CONTENTS 23.4 Concluding remarks Literature notes Appendix Exercises A closer look at the labor market Introduction Themes Problems VI UNCERTAINTY AND EXPECTATIONS Uncertainty, rational expectations, and staggered wage setting Simple expectation formation hypotheses The rational expectations hypothesis Two model classes Rational expectations Solving a simple RE model Wage setting in advance A benchmark model with synchronous wage setting Wage setting one period in advance Solving the benchmark model Asynchronous wage setting for several periods: Fischer s approach The original Fischer model A modified Fischer model Asynchronous wage setting with constant wage level for several periods: Taylor s model Conclusion Appendix Exercises Forward-looking rational expectations Expectational difference equations Solutions when a < Repeated forward substitution The fundamental solution Bubble solutions When rational bubbles in asset prices can or can not be ruled out Time-dependent coeffi cients
13 CONTENTS xiii Three classes of bubble processes Solutions when a > Concluding remarks Literature notes Appendix Exercises Applications to New Classical and Keynesian models New Classical Macroeconomics The New Classical school An NCM model Weak and strong policy ineffectiveness Alternative specifications and extensions Discussion The Lucas critique of econometric policy evaluation Paper money and hyperinflation Announcement effects Is increased wage flexibility stabilizing? Dynamic AD-AS model with uncertainty and nominal rigidities Dynamic responses Depression economics Conclusion Appendix Can rational bubbles be ruled out in general equilibrium? Introduction Finite number of agents Infinite number of agents: OLG models No bubbles The Diamond-Tirole model Stochastic bubbles Concluding remarks Notes on the literature Appendix Problems VII FITTING THE PARTS TOGETHER: THE MEDIUM
14 xiv CONTENTS RUN Business fluctuations Some business cycle facts Key terms from the business cycle vocabulary A quick glance at the Great Recession and its aftermath Conclusion Literature notes Exercises The real business cycle theory A simple RBC model A deterministic steady state* On the approximate solution and numerical simulation* Log-linearization Numerical simulation The two basic propagation mechanisms Limitations Technological change as a random walk with drift Concluding remarks Literature notes Exercises Keynesian perspectives on business cycles A minimalist Keynesian medium-run model in discrete time Vicious and virtuous circles Precautionary saving Consumption/saving under alternative forms of uncertainty Precautionary saving in a macroeconomic perspective On the distinction between risk aversion and prudence* Risk aversion and risk premium The degree of prudence Literature notes Appendix Exercises The New Keynesian workhorse model Main text Problems Credit and business cycles 1103
15 CONTENTS xv 34 Issues in monetary and fiscal policy Outlook 1107 VIII SUPPLEMENTS Hints and solutions for selected exercise problems Math tools Equation systems and causal analysis 1115
16 xvi CONTENTS
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