Introduction: Modern Macroeconomics
- Sources: Wickens Macroeconomic Theory Ch. 1
E. Prescott (2004) The Transformation of Macroeconomic Policy
and Research (Nobel Lecture).
R. Lucas (1980) ‘Methods and Problems in Business Cycle
Theory” Journal of Money, Credit and Banking
S. Rebelo (2005) Real Business Cycle Models: Past, Present and
Future NBER Working Paper, no. 11401.
M. DeVroey (2016) A History of Macroeconomics.
- Questions:
- Why a second macroeconomics course?
- What is ‘Modern Macroeconomics’?
A Quick History and Overview of Macroeconomics
- Macroeconomic concerns:
- Business cycles: cyclical fluctuations in the economy
(recessions, depressions and booms)
- Economic growth: long-run growth in total output and total incomes.
- Macroeconomic variables: GDP, unemployment, price level inflation,
interest rates, etc.
-Can we model and explain these variables and so address questions about
business cycles and economic growth?
Early Economics:
- Pre-industrial revolution:
- economies dominated by agriculture
- cycles? boom: good harvest
bust: bad harvest.
- no modern business cycle.
- Growth? not much of an issue pre-1800.
Here’s England (source: G. Clark Farewell to Alms):
- Decades long cycles in the standard of living but no long-run
improvement.
(Classical or Malthusian model: tried to explain this; technological progress only increases population in the long-run – no effect on living standards)
- Macroeconomics in early economics?
- the Classical model is a macroeconomic model (concerned
with aggregates) but for a very different economy than ours.
- scattered pieces have survived in macroeconomics
- David Hume: money supply and inflation (neutrality)
- Thomas Malthus: insufficient aggregate demand and
recessions.
- Industrial revolution:
- Creates a new kind of economy.
- Larger manufacturing sectors, urbanization, more
specialization, more market exchange, financial systems.
- Standards of living increasing: growth is normal!
- Cycles? booms, recessions and depressions in these new
economies seem to be regular events.
e.g. United States 1854-1919: 16 business cycles http://www.nber.org/cycles/cyclesmain.html
- Explaining the new economy:
- Decline and fall of the Classical model: old model can’t explain sustained growth.
- Rise of microeconomics:
- model exchange through markets
- a model of a self-regulating economy
(prices adjust to coordinate decisions and clear
markets)
- Early ideas on business cycles: several early theories, no
dominant view
- Credit markets and finance seem important in early crises.
- credit to farmers, finance and speculation in new industries e.g. railways.
e.g. “Austrians”: cycles of innovation and investment can
give rise to booms and busts.
(part of self-regulating economy: see "Fear the
Boom and Bust" video)
- Early monetary economics: Irving Fisher
- Quantity Theory: MV = PY
M= money supply P = price level
V = velocity of money Y = real GDP
V – fixed by transactions technology (type of money;
state of financial system)
Y – at full employment level (self-regulating!)
Given V and Y: M determines P.
- Empirical research on business cycles: Wesley Mitchell in the U.S.
- Empirical definition of a business cycle; stages of business cycles; what happens during a business cycle?
(pre-cursor of NBER business cycle dating)
- Work on defining and measuring aggregate economic variables (GDP, Consumption, Investment, etc.): how do they change over the cycle?
- Lucas (1980) “Methods and Problems of Business Cycle Behavior” Journal of Money, Credit and Banking summarizes Mitchell’s findings:
“the central finding ... was the similarity of all peacetime cycles with one another .... in the sense that each cycle exhibits about the same pattern of co-movements among variables as do the others”
- Gives rise to attempts to explain the regularities Mitchell and others documented.
- what underlies the typical cycle?
e.g. early-Keynes – a view focused on spending components
(Treatise on Money, 1930)
- This line of research is displaced by the Great Depression: an atypically severe recession.
The Great Depression of the 1930s:
- Severe, long-lasting depression in the industrialized countries.
(UK: stagnation even earlier – 1920s)
- Seemed inconsistent with a self-regulating economy.
- New approaches needed to explain this phenomena?
- John Maynard Keynes:
- A model where a Depression is caused by a shortfall in
Aggregate Demand.
- Business cycles the focus.
- Keynesian economics.
Traditional Macroeconomics:
- Keynesian economics: macroeconomics a separate part of economics.
- Focus on business cycle fluctuations.
[ Output gap: Actual GDP -Potential GDP (<0 recession) ]
- Arises during the Great Depression of the 1930s.
- Why do recessions and depressions occur?
- Policy: can governments prevent or cure recessions?
- Answers in Keynesian macroeconomics:
- Recessions are due to a shortfall of Aggregate Demand.
- Governments can adopt policies to boost aggregate demand.
- Government: a role to play in stabilizing the economy (stabilization policy)
- Fiscal policy (government spending, tax and transfer policies)
- Monetary policy: money supply control & short-term interest rates.
- Short-run focus: length of the business cycle – economy in the next few years.
- Methods and Modelling approaches:
- Focus on aggregate relationships
- modelling the spending components of the National income
constraint (Y=C+I+G+X-M).
- “sensible”, "intuitive" stories justifying relationships
- relationships suggested by the data e.g. Phillips Curve.
- wage rigidity: also suggested by the data
- typically these relationships were not derived from models of
individual behavior.
i.e. no, or limited, “microfoundations” Is this "ad hoc"?
e.g. Income-Expenditure Model (underlies IS curve in IS-LM)
AE = C(Y,r) + I(r) + G
AE = aggregate expenditures on final goods and services
C = consumption spending by households
I = investment spending by businesses
G = government spending on final goods and services
Y = Total Income in the economy (GDP), r=interest rate
C(Y,r) is the consumption function (an aggregate relationship)
I(r) investment function also an aggregate relationship.
Equilibrium: AE = Y
Gives: Y = C(Y,r) + I(r) + G
(relationship between Y and r where goods market is in
equilibrium -- IS curve! )
LM curve: starts with another aggregate relationship the real money demand function. MD/P=MD(Y,r).
etc.
- Econometric methods used to fit aggregate relationships to the data: gives
rise to forecasting models.
- Some key figures?
John Maynard Keynes: General Theory of Employment, Interest and Money, 1936.
John Hicks (1937) “Mr.Keynes and the Classics” Econometrica. (IS-LM model – a more formal version of Keynes).
P. Samuelson's 1st yr. text 1948: macroeconomics first, Keynesian approach.
James Tobin, Franco Modigliani: leading figures in the 1950s-1970s
Macroeconometric modellers e.g. Lawrence Klein, Cowles Foundation (forecasting models)
- Evolution of Traditional Macroeconomics:
- Tensions:
Demand-side focus -- shouldn't supply matter too?
Short-run focus: what about the macroeconomy in the long-run?
Active role for government: unattractive to conservatives
Methods: logically unsatisfactory? "ad hoc" relationships.
- Keynesian model: model of an economy in recession.
- what about economies that are not in recession?
- too focused on the Great Depression? is it a good model of a typical cycle?
- Economies near full-employment:
Are simple Keynesian models inadequate for such economies?
Are Supply-side issues more important near full-employment?
Problems of the 1970s: a Challenge to the Traditional Approach
- 1970s: rising inflation:
- Stagflation and the OPEC oil price shocks
- rising unemployment and inflation: vs. Phillips curve.
- supply-side changes might explain it !
- Productivity slowdown later 1970s:
US Labour Productivity growth rate:
1947-55 3.2% 1975-85 1.4%
1955-65 2.6% 1985-95 1.5%
1965-75 2.2% 1995-05 2.9%
- more interest in economic growth and the long-run.
- dynamic, growth models needed.
- Is economic growth more important than cycles?
Response 1: Adapt "Traditional Macroeconomics"
- Could it be saved?
- Monetarism: monetary factors and aggregate demand (Milton Friedman)
- Bring "Aggregate Supply" into the model: adapt traditional models.
- Phelps and Friedman: Expectations-Augmented Phillips curve
(early 1970s)
- Late 1970s-early 1980s: Aggregate Demand - Aggregate Supply model
- Dornbusch and Fischer intermediate macroeconomics text.
- models with a Keynesian short-run and a self-regulating, supply
response in the long-run.
- models with a long-run equilibrium ‘natural rate of unemployment’.
("Saltwater" macroeconomics: MIT, Harvard, Yale, Berkeley)
- Macroeconometric forecasting models.
- incorporated and still often incorporate this structure.
- fit aggregate relationships to the data.
- simultaneous equation forecasting models.
- many commercial forecasting models still have this structure.
(see for example Ray Fair’s site: http://fairmodel.econ.yale.edu/mmm1.htm)
- success for a macroeconomist: to have their equation included in
standard forecasting models (Prescott, 2004)
Response 2: Abandon Traditional Macroeconomics
- Problems above.
- Logical dissatisfaction
- Ad hoc nature of aggregate relationships
- Ad hoc expectations assumptions: should be forward-looking and rational.
- Lucas critique:
- parameters of aggregate relationships unstable.
(reflect decision-makers' responses to the environment they face)
- parameters change as environment changes.
- Consequence: models are not useful for forecasting.
Robert Lucas (U. Chicago)
- Indeed old-style macroeconometric models are inconsistent with
dynamic microeconomic theory.
- Logical appeal of a macroeconomic model built from the ground up.
- model each decision-maker in the economy.
- economy is the outcome of interaction between these individuals.
- Look to the successes of general equilibrium modelling
(microeconomics): 1950s, 1960s. Arrow-Debreu model,
methods.
- Inconsistencies with microeconomics: also motivate new approaches
- different methods
- different results:
- invisible hand (micro) vs. Keynesian stabilization policy.
- traditional macroeconomics: greater government role.
- Political leanings and attitude to traditional macroeconomics.
- Technical and computational methods
- these had advanced significantly since Keynes’ day.
- has expanded our ability to construct model economies with
microfoundations. (see Lucas, 1980)
- "Freshwater" macroeconomics is the result.
(Chicago, Minnesota, Rochester)
The Rise of Modern Macroeconomics:
- Early work in 1970s.
- 1980s to early 1990s new approach spreads
- Becomes the dominant approach in: theoretical macroeconomics research
Ph.D. level macroeconomics training
but not in forecasting and often not in policy
- Some major figures:
Edward Prescott Robert Lucas
- Focus on "microfoundations":
- microeconomic approach to macroeconomics
- models of rational behavior by households and businesses
- macroeconomic relationships should be derived from individual behavior.
- Dynamic stochastic general equilibrium (DSGE) models.
- Models are dynamic (D in DSGE):
- focus on decision-making over time: current decisions depend on past
decisions and expectations about the future.
- optimal intertemporal adjustment to shocks.
- explanations of economic growth a natural part of a dynamic model.
- Models are typically stochastic (S):
- uncertainty: economies are subject to stochastic shocks.
- expectations and expectations formation important.
- focus is on forward-looking, ‘rational expectations’.
- Early models are equilibrium models (GE):
- market-clearing assumptions; focus on flexible prices and market-clearing.
- Lucas wants an equilibrium model of business cycles: optimal, dynamic
response to shocks (early-Lucas: monetary policy)
- Real Business Cycle (RBC) approach:
- can supply (productivity) or other real shocks explain business cycles?
(vs. Keynesian views that highlight aggregate demand)
- focus is on the typical cycle (was Keynesian focus on the Great Depression
a wrong turn? )
- cycles in these models will be equilibrium cycles and will reflect decisions
of rational decision-makers acting optimally.
(Welfare economics: competitive equilibria are efficient, so are cycles efficient?)
- RBC seminal paper: F. Kydland and E. Prescott (1982) “Time to Build and Aggregate Fluctuations” Econometrica v. 50, 1345-1370.
- three innovations (according to Rebelo, 2005):
(1) Business cycles can be studied with dynamic general equilibrium models (rationality, optimizing decision-makers, competition);
(2) Unified business cycles and growth theory: business cycle models must be consistent with empirical regularities of long-run growth;
(3) Evaluation:
- calibrate models with parameter estimates drawn from microeconomic literature or using long-run properties of the economy;
- use the calibrated model to create artificial data that can be
compared to patterns in actual data.
- Much of modern macroeconomics follows this approach.
- Prescott’s (2004) Nobel Prize lecture:
“Models after the transformation are dynamic, fully articulated model economies
in the general equilibrium sense of the word economy. Model people maximize
utility given the price system, policy, and their consumption possibility set;
firms maximize profits given their technology set, the price system, and policy;
and markets clear. Preferences, on the one hand, describe what people choose
from a given choice set. Technology, on the other hand, specifies what outputs
can be produced given the inputs. Preferences and technology are policy invariant.
They are the data of the theory and not the equations as in the system-of-equations
approach. With the general equilibrium approach, empirical
knowledge is organized around preferences and technology, in sharp contrast
to the system-of-equations approach, which organizes knowledge about
equations that specify the behavior of aggregations of households and firms.”
New Keynesian models:
- Dissatisfaction with the new RBC approach:
- RBC approach seems to be insufficient to explain actual business cycles.
- recessions are too persistent;
- money and monetary factors: empirically important but not in RBCs.
- Shocks in RBC models: productivity, depreciation and taste shocks
- are these plausible causes of actual recessions?
(Delong: "forgetting, rusting, vacationing")
- Are RBC "microfoundations" the right "microfoundations"?
- RBC: competitive equilibrium models
rational expectations or perfect foresight
representative agent models etc.
- New Keynesian approach
- adopt approaches and tools of "modern macroeconomics"
( Dynamic Stochastic General Equilibrium approach )
- Add sticky prices and or wages.
- "microfoundations" for these are provided.
- models of price setting under imperfect competition.
- contracting models.
- Michael Woodford (Columbia) a major New Keynesian figure.