ADVANCED MODERN MACROECONOMICS
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1 ADVANCED MODERN MACROECONOMICS ANALYSIS AND APPLICATION Max Gillman Cardiff Business School, Cardiff University Financial Times Prentice Halt is an imprint of Harlow, England London New York Boston San Francisco Toronto Sydney Singapore Hong Kong Tokyo Seoul Taipei New Delhi Cape Town Madrid Mexico City Amsterdam Munich Paris Milan
2 *&<. -*,.' BRIEF CONTENTS * * Custom publishing Preface Acknowledgements xiv xv xvii Part 1 MICROFOUNDATIONS OF MACROECONOMICS 1 1 Overview of the book 3 Part 5 GROWTH, HUMAN CAPITAL AND BUSINESS CYCLES 11 Exogenous growth 12 Human capital and endogenous growth 13 Explaining cycles and trends 14 International trade Part 2 LABOUR AND GOODS MARKETS 25 2 Labour, leisure and productivity 27 3 Employment cycles and taxes 61 4 Trade in labour and goods markets 97 Part 3 CAPITAL AND GOODS MARKETS Savings and investment Capital policy and business cycles Trade in physical capital markets 173 Part 4 MODERN AS-AD Dynamic analysis and AS-AD Employment Dynamic AS-AD solution methodology 264 Part 6 RISK, BANKING AND ASSETS Incomplete markets and banking Investment and banking productivity Asset prices and finance 484 Part 7 FISCAL AND MONETARY POLICY Public finance Taxes and growth Monetary theory and policy 559 Index 595
3 CONTENTS Custom publishing Preface Acknowledgements j Parti j MICROFOUNDATIONS OF MACROECONOMICS Chapter 1 Overview of the book Introduction Learning objective Who made it happen? The microfoundations approach Building macro from micro: new elements Microeconomic foundations of macroeconomics Static versus dynamic general equilibrium Dynamic AS-AD General equilibrium output and input dimensions Consumption smoothing Taxes, regulations and inefficiencies Comparative statics and business cycles A focus on productivity changes Basic puzzle of too much smoothing Human capital Banking in general equilibrium Private and public finance I Explaining business cycles and growth Content by margins Consumption, permanent income and wealth A methodological outline Closed economy methodology Open economy methodology Suggested ways to use the text Possible course usage of text A summary Questions References 24 Part 2 LABOUR AND GOODS MARKETS Chapter 2 Labour, leisure and productivity Introduction Building on the last chapter Learning objective Who made it happen? Representative agent goods-leisure choice Utility and production elements Time and goods constraints Equilibrium with capital fixed Example 2.1: Baseline model Smoothing consumption Goods productivity increase Example Substitution and income effects Example 2.3: An eight-hour day Example 2.4: Linear indifference curves Consumer and firm problems Consumer: demand for goods,. supply of labour Firm: supply of goods, demand for labour Aggregate demand and supply Example The goods markets: AS and AD Aggregate labour market Market equilibrium: the real wage rate General equilibrium representation Labour productivity increase Example General equilibrium Application: productivity and growth Growth policy US legislation Modern economic views on stabilisation vs growth 53
4 2.8 Questions References Appendix A2: Optimisation General representative agent problem Simpler one-step method of maximisation Separate decentralised problems Cobb-Douglas profit 59 Chapter 3 Employment cycles and taxes Introduction Building on the last chapters Learning objective Who made it happen? Business cycles and employment Internal versus external labour margins Time endowment increase Example Economic expansion and contraction Example 3.2: Expansion Example 3.3: Contraction Unemployed labour Example 3.4: A fixed wage during. a contraction Excess labour supply and goods demand A goods tax Example 3.5: Goods tax and transfer Labour market After tax wage rate and tax wedge General equilibrium tax wedge Zero government transfer \ C + G = Y Example Goods market Labour market Labour tax Example Comparison of taxes Regulation and implicit taxes Rents and corruption Economics of regulation Applications Moral hazard Unemployment benefits as insurance Taxes and employment policy Regulation of airlines, oil and pollution Questions References 96 Chapter 4 Trade in labour and goods markets Introduction and summary Building on the last chapters Learning objective Who made it happen? Two-agent model Example 4.1: Autarky Decentralised problems Example 4.2: Autarky Example 4.3: Trade Market for goods Market for labour General equilibrium representation Trade flows Marginal productivity theory of income distribution Multiple heterogeneous agents Example 4.4: More B than A Trade flows Changes in the distribution of income Example 4.5: Education increase Example 4.6: Immigration restrictions Taxes and two classes of agents Example 4.7: Tax both and transfer to A As an unemployment/ welfare system Applications UK's Magna Carta 1297, Australia's ASEAN FTA 2009 and globalisation Immigration waves and rural-urban migration Questions References 120 Part 3 CAPITAL AND GOODS MARKETS Chapter 5 Savings and investment 5.1 Introduction Summary Building on the last chapters Learning objective
5 5.1.4 Who made it happen? Representative agent intertemporal economy Log-utility and Cobb-Douglas production Example Growth and welfare Graphically Productivity change Example Substitution and income effects Consumer and firm problems Example Capital market Goods market General equilibrium Growth rate implications Capital productivity Example Graphically Current period income endowment Example Decentralised problem Applications Savings rate, permanent income and debt crisis Questions References Appendix A5: Alternative two-period formulations 150 Chapter 6 Capital policy and business cycles Introduction Building on the last chapters Learning objective, Who made it happen? * Business cycles and investment Economic expansions and contractions Example 6.1: Expansion Example 6.2: Contraction Unemployed capital Example 6.3: Fixed price Excess capital supply and goods demand A tax on capital income Budget constraints Example Capital policy alternatives Applications Capital market regulation, usury and economic science Questions References Chapter 7 Trade in physical capital markets Introduction Building on the last chapters Learning objective Who made it happen? Two-period 'small open' endowment economy Wealth constraint Example 7.1: Lender Example 7.2: Interest rate increase Consumption smoothing and time preference Example 7.3: Borrower Example 7.4: Borrower with interest increase Two-agent general equilibrium Example 7.5: Decentralised autarky Capital market Goods market General equilibrium Trade Example Capital market Goods market Applications Small open economies Fostering capital market trade Keynes, his revision, and the Marshall Plan Soros, the Soviet Union and China War versus globalisation Questions References Part 4 MODERN AS-AD Chapter 8 Dynamic analysis and AS-rAD Introduction Building on the last chapters Learning objective Who made it happen? The recursive problem General equilibrium representative agent problem Consumer and firm Droblems
6 8.4.1 Consumer Goods producer Aggregate demand: AD Zero growth Consumption demand as a fraction of permanent income Permanent income and wealth Adding capital maintenance and getting AD Aggregate supply: AS Marginal cost of output Marginal cost in terms of relative price of output Baseline calibration Example C + I = Y Calibration of the AS curve Graphical AS-AD equilibrium Equilibrium wage rate Consumption and output General equilibrium Productivity increase Example Graphically Equilibrium wage Consumption and output General equilibrium Time endowment increase Example Graphically Equilibrium wage Consumption and output General equilibrium Applications Aggregate supply and demand shifts A view of supply side economics \ Say's law Supply side and growth Questions References 237 Chapter 9 Employment Summary/introduction Building on the last chapters Learning objective Who made it happen? Aggregate labour supply and demand Example 9.1: Labour market equilibrium Equilibrium wage Productivity increase Example Equilibrium wage Time endowment increase Example Equilibrium wage Business cycle explanation Example Example 9.5: Contraction Fixed wage unemployment and depressions Marginal productivity Example Taxes and employment Example Equilibrium wage Consumption and output Labour market General equilibrium Applications Hours per week, taxes and regulations Questions References 263 Chapter 10 Dynamic AS-AD solution methodology Introduction Building on the last chapters Learning objective Who made it happen? Full model solution Capital stock state variable AS-AD solution approach Alternative solution approach All other variables Baseline calibration of the solution Target values Baseline Examples 8.1 and Consistency of the solution Calibration of the full solution Comparative statics of AS-AD analysis Productivity change: Examples 8.2 and Time endowment change: Examples 8.3 and Business cycle explanation Example Example Other comparative statics and k Depreciation rate change Leisure preference change Time preference change Labour share change 279
7 10.7 Unemployment with a fixed wage Example Taxes and employment General solution Example Application: capital derived graphically Baseline dynamic model Example of comparative statics Questions References 293 Part5 GROWTH, HUMAN CAPITAL AND BUSINESS CYCLES Chapter 11 Exogenous growth Introduction Building on the last chapters Learning objective Who made it happen? Causes of sustained growth Principle of sustained growth Exogenous technological progress Stylised facts Growth accounting Balanced growth path equilibrium Consumer demand with growth Consumption in terms of permanent income Aggregate demand with growth Aggregate supply with growth AS-AD analysis Example 11.1: Calibration Example 11.2: Alternative baseline calibration Consumption and output Labour market ' The exogenous growth process Example 11.3: Continuous shifts in A Gt Labour market General equilibrium Trend in time endowment Example 11.4: Opposite trends in Tand As Labour market Applications TFP, Japan's lost decade and the Minnesota School Questions References Appendix A11: Solution methodology for exogenous growth Example 11.1: Capital stock solution Example 11.2 Example 11.3: Exogenous growth process Example 11.4: Trends in both time and goods endowment Chapter 12 Human capital and endogenous growth 12.1.Introduction Building on the last chapter Learning objectives Who made it happen? 12.2 Human capital investment Relation to exogenous growth Second sector and endogenous growth Growth with human and physical capital Second intertemporal capital margin AS-AD with human capital Permanent income and wealth Aggregate demand AD Aggregate supply AS Example 12.1: Baseline calibration Equilibrium wage rate Consumption and output ' General equilibrium Labour market Endogenous growth process Example 12.2: BGP growth Labour market Labour intensity increase Example Interpretation Special cases of endogenous growth Example 12.4: Human capital only Example 12.5: Physical capital only Applications: income distribution, Marx and human capital Questions References Appendix A12: Solution methodology Solving for g with AS-AD Quadratic equation solution of growth rate 356
8 Chapter 13 Explaining cycles and trends Introduction Building on the last chapters Learning objective Who made it happen? Business cycles with endogenous growth Goods sector productivity increase Example Equilibrium wage Consumption and output Labour market General equilibrium Human capital sector productivity increase Example Equilibrium wage Consumption and output Labour market General equilibrium Economic expansion and contraction Consumption-output puzzle Two-sector business cycle models Cyclical change in growth rate Shocks within a business cycle model Example 13.3: Zero persistence Example 13.4: Full persistence Example 13.5: High degree of shock persistence Growth accounting Historical trends with endogenous growth Time allocation trends Economic development Industrial transformation Policy Application: capital symmetry in growth theory Questions References 390 Chapter 14 International trade Introduction Building on the last chapters Learning objective Who made it happen? Autarky Example 14.1: Autarky Labour market Trade World market clearing Solution methodology Example Graphing AS-AD Trade flows Labour market Trade Factor price equalisation Interest rate Wage rate Capital to effective labour ratios General equilibrium Autarky Trade Savings and investment Changes in productivities Change in human capital investment productivity Exogenous growth Example 14.3: Numerous agents Applications Growth convergence Leontief paradox Savings-investment and Feldstein-Horioka puzzle Questions References 424 Part 6 RISK, BANKING AND ASSETS Chapter 15 Incomplete markets and banking Introduction Building on the last chapters Learning objective Who made it happen? Two-state analysis in general equilibrium Costly transfer of income across states Complete consumption smoothing Log-utility and linear production Example 15.1: Baseline Example 15.2: Consumption tilting Example 15.3: Change in transfer productivity 439 Consumer and firm decentralised problems Consumer problem Firm problem 441
9 Market clearing equilibrium The financial intermediation approach Banking across states of nature Consumer problem Bank problem Market clearing Example 15.4: Equal probabilities of states Example 15.5: Good state more probable Example 15.6: Rare bad state Bank production factors Example 15.7: Productivity factor Example 15.8: Larger labour costs Example 15.9: High labour cost Aggregate risk: falling bank productivity in the bad state Application Unemployment and health insurance Questions References 457 Chapter 16 Investment and banking productivity Introduction Building on the last chapters Learning objective Who made it happen? Savings-investment intermediation Consumer problem Goods producer problem Bank technology for producing loans Bank profit optimisation problem Solution with deposits equal loans * Example 16.1: Marginal cost and bank supply AS-AD with banking Example 16.2: Baseline calibration with banking Bank productivity and bank crises Example 16.3: The bank crisis Interest rate spread Labour market and bank crisis General equilibrium comparison Crashes of 1929 and Application: bank insurance policy Deposit insurance with risk-based premiums Policy for global bank failure, aggregate risk and moral hazard International finance systemic insurance 478 Questions 479 References 480 Appendix A Example Example Chapter 17 Asset prices and finance Introduction Building on the last chapters Learning objective Who made it happen? Modelling the return on bonds Extended baseline dynamic model Equilibrium condition for bonds Example 17.1: Alternative bond pricing Equity capital asset market The equity premium, A model of asset prices under certainty Value of goods producer Limiting discounted price: transversality Example 17.2: Stock price ; and capital Under uncertainty Example 17.3: Asset pricing Example 17.4: Expectations hypothesis Prices and dividend streams Example 17.5: Constant dividend stream Asset prices and growth Example 17.6: Exogenous growth Endogenous growth Deriving the equity premium Example! 7.7: Empirical failing of exogenous growth Equity premium and human capital Application: historical price-earnings ratios Questions References 505
10 Part 7 FISCAL AND MONETARY POLICY Chapter 18 Public finance Introduction Building on the last chapters Learning objective Who made it happen? Government budget and wealth constraints Initial period revenue v and spending Subsequent periods Wealth constraint Bond transversality and the wealth constraint Ricardian equivalence Impossibility theorem of non-ricardian equivalence BGP equilibrium government spending Tax component Government spending component Money printing component Wealth constraint with balanced growth With inflation Example 18.1: Seigniorage wealth Government debt from deficits Debt and deficit to GDP ratios Example 18.2: Maastricht Treaty debt and deficit limits Optimal public finance Spending as a constant share of output Endogenous growth and a constant share Example 18.3: Optimal taxes, debt and deficit Applications Greek debt crisis and Ricardian equivalence Taxes and government size Flat tax policy around the world Questions References 527 Chapter 19 Taxes and growth Introduction Building on the last chapters Learning objective Who made it happen? Capital income tax AS-AD analysis Solution methodology Example 19.1: Baseline calibration Labour market General equilibrium Labour income tax AS-AD analysis Solution methodology Example Labour market General equilibrium Consumption VAT Example Applications Value added taxes Application: trickle down economics Capital, market interest rates and equity value 555 ~ 19.6 Questions References 558 Chapter 20 Monetary theory and policy Introduction Building on the last chapters Learning objective Who made it happen? The Fisher equation: linking nominal and real The separation of real from nominal factors The nominal interest rate and the Fisher equation Unexpected inflation and the Phillips curve Interpreting the Phillips curve relation Money supply, inflation and government expenditure Money supply growth and government spending Money supply and the. inflation rate Zero growth inflation rate. determination Example 20.1: Financing high spending when growth is zero Example 20.2: Financing low spending when growth is zero The inflation tax Inflation and growth 567
11 20.4 Inflation tax dynamics and hyperinflation Inflation dynamics Government spending and money supply Hyperinflation in Europe and across the world The monetary economy AS-AD analysis of inflation effects Example Labour market effects of inflation General equilibrium Endogenous growth and the inflation tax AS-AD analysis Solution methodology Example 20.4: Inflation tax and growth Labour market General equilibrium Exogenous growth versus endogenous growth Level of the inflation tax 20.7 Application: central bank policy Deriving a Taylor rule Taylor rule as policy in general equilibrium Financial crises of the last decade 20.8 Questions 20.9 References Index 595 Supporting resources Visit to find valuable online resources: For instructors Complete, downloadable Instructor's Manual PowerPoint slides that can be downloaded and used as OHTs For more information please contact your local Pearson Education sales representative or visit
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