Introduction to Macroeconomics Vivaldo Mendes a ISCTE IUL Department of Economics September 2011 (Vivaldo Mendes ) Macroeconomics September 2011 1 / 45
I Useful information (Vivaldo Mendes ) Macroeconomics September 2011 2 / 45
Useful information Useful information Lecturer: Vivaldo Mendes (vivaldo.mendes@iscte.pt) Offi ce: Room 519 (Building II) Phone numbers: internal (795191), external (217903959) Classes: Tuesdays 18.00h 20.00h, Room 229 or on a Computer Lab (to be announced) Course homepage: there will be one operational soon, with news and materials online address: http://mac.de.iscte.pt/ (Vivaldo Mendes ) Macroeconomics September 2011 3 / 45
Useful information Grading Grading: this process includes two alternatives: Option A Midterm test (30%): There will be one midterm test on a date to arrange Final test (40%): The final test will be on January 2011 A group essay (30%): on a subject discussed in the course Option B Midterm test (40%): There will be one midterm test on a date to arrange Final test (60%): The final test will be on January 2011 Active participation:in classes is welcome, it s very useful for learning and grading The group essay: not be developed under "self management" (Vivaldo Mendes ) Macroeconomics September 2011 4 / 45
Useful information Teaching approach The teaching material requires 13 weeks x 2 hours a week Some topics: will be covered in just one week Some topics: require two or more weeks A step ladder approach to teaching: If you miss one step, it s more diffi cult to put your feet on the next... Oriented towards "how to do": students are expected to master practical tools... not just descriptive general knowledge (Vivaldo Mendes ) Macroeconomics September 2011 5 / 45
Useful information Teaching approach (cont.) Computers: they will be used as much as possible (Matlab) Good knowledge of mathematics: it helps, however it is not enough Lack of such knowledge: do not worry, you will not be left behind...... if you pay careful attention when the crucial maths concepts are introduced in classes The course is intended to be "self contained" Mathematics that matters are basic knowledge of: Derivatives Difference equations Optimization (Lagrangian) Matrices (Vivaldo Mendes ) Macroeconomics September 2011 6 / 45
Useful information The textbook No textbook: there is no adopted textbook Publicly available lecture notes: will be provided (topic by topic) Main reasons: Students save time Lecture notes are "tailored" to each topic Major available textbooks require a much lengthier course (not just 30 hours course) Some major postgraduate macro textbooks available: Michael Wickens (2008). Macroeconomic Theory:A Dynamic General Equilibrium Approach, Princeton University Press Lars Ljungqvist and Tom Sargent (2004). Recursive Macroeconomic Theory, 2nd edition, MIT Press Stephen Williamson (2011), Macroeconomics, 4th Edition, Prentice Hall a good choice for those with little economics background (Vivaldo Mendes ) Macroeconomics September 2011 7 / 45
A quick guided tour Useful information 1 Introduction to macroeconomics (1 week) 2 Major stylized facts about business cycles (1 week) 3 Introduction to Matlab (1 week) 4 Solving models with rational expectations (1 week) 5 The Real Business Cycle model (2 week) 6 The New Keynesian model (2 week) 7 Central banks, commitment, credibility and the financial crisis (1 week) (Vivaldo Mendes ) Macroeconomics September 2011 8 / 45
Useful information II - What is macroeconomics? (Vivaldo Mendes ) Macroeconomics September 2011 9 / 45
What is macroeconomics? The terrible importance of macroeconomics The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. John Maynard Keynes (Vivaldo Mendes ) Macroeconomics September 2011 10 / 45
What is macroeconomics? What is macroeconomics? Analyses the interactions among 4 aggregate markets: Market for goods&services Money and financial market Exchange or FX market Labor market Prices and quantities: explain how these are determined in each market in interaction Time periods: considering different periods for the analysis: Short term: business cycles Long term: economic growth, sustainability of social security and of public debt, among others Please, don t mix up short term and long term phenomena (Vivaldo Mendes ) Macroeconomics September 2011 11 / 45
What is macroeconomics? What is macroeconomics? (continued) Different assumptions: considers different crucial assumptions: Markets work perfectly well: Classical macroeconomics Markets show large imperfections: Keynesian macroeconomics Economic policy: give answers about how and whether the government should intervene in the economy in order to increase social welfare: Classicals: Active economic policy is undesirable... reduces social welfare Keynesians: Market failures are pervasive and require active public intervention... to boost social welfare Try to get this clear opposition between the two schools in your mind (Vivaldo Mendes ) Macroeconomics September 2011 12 / 45
What is macroeconomics? Major agents in macroeconomics Private agents Households Firms Banks (money) and financial institutions (financial assets) Agents with a political power Government Central Bank (in all OECD countries, this bank is totally independent from the Government) Trade Unions and Employers Associations Foreign agents (agents living in foreign economies) (Vivaldo Mendes ) Macroeconomics September 2011 13 / 45
What is macroeconomics? III - The current sate of macro (Vivaldo Mendes ) Macroeconomics September 2011 14 / 45
The field of macroeconomics has witnessed in recent years the development of a new generation of small-scale monetary business cycle models, generally referred to as New Keynesian (NK) models or New Neoclassical Synthesis models... [integrating] Keynesian elements (imperfect competition, and nominal rigidities) into a dynamic general equilibrium framework that until recently was largely associated with the Real Business Cycle (RBC) paradigm. They can be used (and are being used) to analyze the connection between money, inflation, and the business cycle, and to assess the desirability of alternative monetary policies. (page 1) (Vivaldo Mendes ) Macroeconomics September 2011 15 / 45 The current state of macro The current state of macro Big turmoil: over the last 30 years, macroeconomics was in big controversies A new consensus: has emerged in macroeconomics over the last 15 years or so... Jordi Gali (2000). New Perspectives on Monetary Policy, Inflation and the Business Cycle, Dep. Economics, Universitat Pompeu Fabra, Barcelona.
The current state of macro The First (Old) Neoclassical Synthesis Young subject: macroeconomics was "born" in the mid 1940 s 1946: the first time the term "macroeconomics" were used in one title (vide Fig 1) Keynesian ideas dominated macroeconomics until early 1070 s The first Neoclassical Synthesis: Keynesian/Classical dichotomy The economy "is" Keynesian in the short term: there is a permanent trade-off between inflation and unemployment that can be exploited by policy makers The economy "is" Classical in the long term: no such permanent trade-off exists In the late 1960 s: serious problems with the Synthesis became evident: empirically and conceptually (Vivaldo Mendes ) Macroeconomics September 2011 16 / 45
The current state of macro Figure 1: first time "macroeconomics" used in a title (Vivaldo Mendes ) Macroeconomics September 2011 17 / 45
The current state of macro Conceptual problems with the Old Synthesis No microeconomic foundations: most functions in the model were totally ad-hoc Backward looking expectations: private agents produce systematic mistakes in their forecasting exercises Irrationality: policy makers were fully-rational agents and knew how the economy works; private agents were "irrational" with little knowledge of how the economy works Total nonsense: admitting that the Central Bank could manage monetary policy to permanently exploit the trade-off between inflation and unemployment Vulnerable to the Lucas critique: if policy makers intervene in the economy, private agents react by changing their choices, so the structure of the economy changes and the public intervention has perverse effects (Vivaldo Mendes ) Macroeconomics September 2011 18 / 45
The current state of macro Empirical problems with the Old Synthesis 1 Real wages: are countercyclical in the model, but procyclical in the economy 2 Stagflation: 1 the early 1070 s put in evidence a very unpleasant reality to which the model could provide no remedy 2 higher and higher unemployment and inflation rates (stagflation) 3 Public debt: increased permanently in almost all OECD countries, with little evidence of a decline in unemployment 4 Monetary aggregates: Central Banks lost the control of these aggregates 5 Basic stylized facts from the business cycles: the model could hardly reproduce these facts (variances, covariances, etc..) (Vivaldo Mendes ) Macroeconomics September 2011 19 / 45
The current state of macro 30 years of revolutions and counter-revolutions The Old Synthesis: stand for the 1950 s and the golden 1960 s Sargent and Lucas: launched the New-Classical model (early 1970 s) Macro with microeconomic foundations Real Business Cycles (RBC): problems with New-Classical model led to the RBC model in the early 1980 s Finn Kydland and Edward Prescott (1982), Time to Build and Aggregate Fluctuations, Econometrica, 50, 1345 1370) New Keynesian Model: problems with the RBC led to the development of the NKM (or the New Synthesis) in the mid 1990 s: Yun, T. (1996). Nominal Price Rigidity, Money Supply Endogeneity, and Business Cycles, Journal of Monetary Economics, 37 (April), 345 70 Now we have a financial crisis: problems for the New Synthesis So far: no clear theoretical answer to the crisis (Vivaldo Mendes ) Macroeconomics September 2011 20 / 45
The current state of macro Main ingredients of the New Synthesis Built upon the Old Keynesian framework... with the usual nominal/real rigidities in price setting... without the problems that pushed the model to serious problems in the early 70s The same functions: IS, LM, Agregate Supply Some new arguments: "forward looking or rational expectations" instead of "adaptive expectations", "Calvo pricing", maximization of utility, and so on... General equilibrium framework: built upon sound microeconomic principles Quantitative simulations: relies a lot on simulations like the RBC literature Contrary to RBC: have a key role to monetary policy and a significant role for fiscal policy (Vivaldo Mendes ) Macroeconomics September 2011 21 / 45
The current state of macro Major predictions of the New Synthesis Four basic predictions: (very important) the instrument of monetary policy ought to be the short term interest rate, policy should be focused on the control of inflation inflation can be reduced by aggressively increasing short term interest rates the central bank should conduct monetary policy adopting a strategy of commitment in a forward-looking environment, instead of discretion The Old model s predictions up-side-down!!! See Figure 2. Problems of the new synthesis: the current financial crisis (Vivaldo Mendes ) Macroeconomics September 2011 22 / 45
The current state of macro Active interest rate policy by central banks The FED now reacts much more aggressively to inflation than in the "old times".12 IPIPIB Indice Preços Implicito no PIB (trimestral).1.08 "FED Funds Rate": 4.8% "FED Funds Rate": 9.7%.06.04.02 1960 1965 1970 1975 1980 1985 1990 1995 2000 (Vivaldo Mendes ) Macroeconomics September 2011 23 / 45
The current state of macro A picture of the success of the receipt (I) 9 LGDP hplgdp 8.5 8 7.5 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000.025 GDPResid 0.025.05 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 (Vivaldo Mendes ) Macroeconomics September 2011 24 / 45
The current state of macro A picture of the success of the receipt (II).02 G(RealGDP).02 G(RealWages).01.01 0 0 1985 1990 1995 2000.04 G(RealGDP).01.04 1985 1990 1995 2000 G(RealWages).02.02 0 0.02.02 1950 1960 1970 1980 1990 2000 1950 1960 1970 1980 1990 2000 (Vivaldo Mendes ) Macroeconomics September 2011 25 / 45
The current state of macro IV - Two notions of equilibrium (Vivaldo Mendes ) Macroeconomics September 2011 26 / 45
Two notions of equilibrium Two notions of equilibrium A competitive or Walrasian equilibrium occurs when: Firms and consumers take all prices as given (no market power) There is perfect information concerning all relevant issues in the market There are no externalities Therefore, prices convey all relevant information, are fully flexible, such that supply = demand in all markets (market clearing). An imperfectly competitive or Non Walrasian equilibrium occurs when: Firms are price makers (they have market power) Information is imperfectly disseminated throughout the markets There may be externalities Therefore, prices may not convey all relevant information, adjust slowly, and thus supply may be different from demand in all markets (non market clearing). (Vivaldo Mendes ) Macroeconomics September 2011 27 / 45
Two notions of equilibrium Perfect Markets: example An increase in demand in a perfectly competitive market: prices are fully flexible to clear the market P Q d 0 Q d 1 Q s P 1 C P 0 A B Q 0 Q 1 Q d 1 Q (Vivaldo Mendes ) Macroeconomics September 2011 28 / 45
Two notions of equilibrium Imperfect Markets: example An increase in demand in an imperfectly competitive market: prices are rigid and the market is not cleared without the intervention of Government P Q d 0 Q d 1 Q s Q s + government supply P 0 A B Government intervention Q 0 Q d 1 Q Rationing due to government intervention (Vivaldo Mendes ) Macroeconomics September 2011 29 / 45
Two notions of equilibrium Two notions of equilibrium: summary Classical economics: the economy tends to work under competitive conditions Keynesian economics: the economy tends to work under imperfectly competitive conditions (Vivaldo Mendes ) Macroeconomics September 2011 30 / 45
A Inflation and Unemployment V - Inflation and Unemployment (Vivaldo Mendes ) Macroeconomics September 2011 31 / 45
A Inflation and Unemployment Inflation and Unemployment in the US: 1947 2010 (Vivaldo Mendes ) Macroeconomics September 2011 32 / 45
A Inflation and Unemployment The natural rate of unemployment: US 1947 2010 A very important concept in macro (Vivaldo Mendes ) Macroeconomics September 2011 33 / 45
The Phillips curve VI The Phillips Curve (Vivaldo Mendes ) Macroeconomics September 2011 34 / 45
The Phillips curve The Phillips Curve as presented for the first time (Vivaldo Mendes ) Macroeconomics September 2011 35 / 45
The Phillips curve The Phillips Curve: basic intuition Recessions imply an increase in unemployment (Vivaldo Mendes ) Macroeconomics September 2011 36 / 45
The Phillips curve The Phillips Curve: a modern view π Curva de Phillips π 1 B π 0 A u 1 u 0 u PE u (Vivaldo Mendes ) Macroeconomics September 2011 37 / 45
Does it exist? The Phillips curve Serious doubts (Vivaldo Mendes ) Macroeconomics September 2011 38 / 45
Inflação Does it exist? (cont.) Serious doubts The Phillips curve 20 15 10 5 0 5 2 3 4 5 6 7 8 9 10 11 Desemprego (Vivaldo Mendes ) Macroeconomics September 2011 39 / 45
Inflação Does it exist? (Cont.) The Phillips curve Serious doubts Even further doubts considering lags (π t, u t 9 ) monthly observations 18 16 14 12 10 8 6 4 2 0 2 0 2 4 6 8 10 12 (Vivaldo Mendes ) Macroeconomics Desemprego September 2011 40 / 45
The Phillips curve The Phillips Curve: conclusions 1 Looking at the figures: reality does not show in any way a Phillips Curve 2 Current values for u and π do not display any clear negative relationship 3 Lagged values of u against current values of π also do not display any clear negative relationship 4 Where is the problem? The Phillips Curve may shift 5 What main factors may shift the Phillips curve: 1 Inflation expectations 2 Productivity 3 Production costs (e.g., energy costs) 4 Other factors (overall confidence) (Vivaldo Mendes ) Macroeconomics September 2011 41 / 45
The Phillips Curve: shifts VI Shifts in the Phillips Curve (Vivaldo Mendes ) Macroeconomics September 2011 42 / 45
The Phillips Curve: shifts Shifts in the Phillips Curve π Curva de Phillips: Deslocamentos π 1 B π 0 A u 0 u PE u PE u (Vivaldo Mendes ) Macroeconomics September 2011 43 / 45
The Phillips Curve: shifts The long term Phillips Curve (Vivaldo Mendes ) Macroeconomics September 2011 44 / 45
The Phillips Curve: shifts Inflation confirms shifts in the Phillips Curve Sometimes inflation goes down even in periods of economic expansion (Vivaldo Mendes ) Macroeconomics September 2011 45 / 45