Macroeconomic Analysis

Macroeconomic Analysis

Econ 506, Fall 1998

End of November

C. Swanson

Our Nine Models

Each is an attempt to formalize a statement, a point, an idea a set of facts, a conjecture or a conceptualization of how a part or all of the economy works. It would be nice if there was just one big model that covered all little models. One day there may be such a model and it may be contain parts of each of these models.

1. Quantity Theory. Main features: (1) The quantity theory: Mv = PY.

(Total effective money supply is equal to—proportional to—the desired quantity of nominal transactions.) (2) The price level is slow to move in the short run but perfectly flexible in the long run. (3) The money supply is well defined, important, generally controllable, and capable of affecting output in the short-run and the price level (only) in the long-run.

Problems: (a) The underlying theory is absent. (b) The proper definition of money is ambiguous (or non-existent). (c) The evidence in support of the model can also be explained by models in which monetary changes are the result rather than the cause of economic changes.

2. The Keynes multiplier. Main feature: (1) Spending by some exogenous institution (such as the government, the foreign sector, or the investment sector) will affect the income and hence the spending of those whose income increases. The total increase in spending is likely to exceed that of the initial exogenous increase. (2) In times of high unemployment, the federal government can use this fact to reduce overall unemployment; it would do so by reducing taxes or increasing spending, where the spending is funded by debt issuance rather than taxation.

Problems: (a) In order to obtain revenue to be used in one sector, the government must extract it from another sector; it must raise current taxes or debt issuance. Either device would reduce the income or money held in the sector extracted from and a negative mulitplier would occur there. The net effect on the aggregate economy would be negative. (b) Despite many attempts, there has not yet been a widely accepted formal model that reproduces the Keyesian multiplier effect. Attempts that have been used usually have the property that when one worker or firm exerts more effort, it is optimal for the other workers to behave similarly (rather than oppositely).

3. Keynesian IS-LM. Main features: (1) The economy is driven by aggregate demand. (2) The economy can be represented in the short-run by an IS-curve and an LM-curve. The IS-curve represents a set of (Y,i) pairs such that output supply equals output demand. The LM-curve represents a set of (Y,i) pairs such that money demand equals money supply. The IS-LM diagram contains four supply and demand curves built into one. (3) Fiscal policy (taxes and spending) can be represented by shifts in the IS-curve. Monetary policy can be represented by shifts in the LM-curve.

Problems. (a) The money supply difficulties that afflict the quantity theory arise here too. (b) The multiplier difficulties that afflict the Keynes’s multiplier arise here too. (c) The model is a short-run model, rather than a long-run model. This makes it difficult to know how to situate each graph. It also calls into question the entire logical apparatus of the model. For example, what sense does it make to discuss the determination of investment in a short-run model? Investment is meaningful only as a long-run enterprise. (Keynes was aware of this difficulty.)

4. Real Bills Doctrine. Main features: (1) The real value of the dollar is determined by the ratio of the real value of assets (the backing) held by the issuer of the currency to the amount of the currency that has been issued and promised out. (2) Raising the quantity of money through Open Market Operations has no effect on the value of the dollar in the short-run or long-run because the ratio of assets to promises is not changed. (3) The quantity of money circulating is not directly important. What matters is whether promises are real (backed), and believed. (4) This model gives a completely different basis for the determination of the price level (and hence inflation) that would be given by a believer in the Quantity Theory. From the point of view of the Real Bills Doctrine, Paul Volcker was a disaster.

Problems: (a) Evidence in support of the Quantity Theory works against this theory. (b) This model neglects a special purpose and function for money. The fact that money has an ease-of-trade property is not subsumed by this theory.

5. Interest Rate Parity. Main feature: (1) The nominal interest rate in the U.S. is equal to the nominal interest rate in a foreign country plus the negotiated rate of depreciation of the dollar vis-a-vis the foreign currency. The expression “negotiated rate of depreciation” means the rate of depreciation that is implicit in the ratio of the forward rate of exchange to the current spot rate of exchange. (2) The argument in support of the the IRP is that when it fails to hold arbitrage opportunities arise. In practice these may exist, but only to a small degree; large ones will be quickly closed.

Problems. (a) Pinning down the correct and appropriate “expected rate of depreciation” and risk premium is tricky. (b) Econometric testing is fun, but tricky.

6. Dornbusch’s Overshooting hypothesis. Main features: (1) Interest rate parity holds. (2) The price level is determined in the long-run by the Quantity Theory. (3) The future exchange rate is determined by Purchasing Power Parity (PPP), the idea that the prices of things should be equal across countries, once the exchange rate is accounted for. (4) Efficient futures markets; the current price of future exchanges—the forward rate—accurately reflects current beliefs and those beliefs accurately reflect what ought to happen. (5) (a) A monetary increase of x percent will cause a depreciation of the currency that is of x percent in the long-run, but more than x percent in the short-run. Between the moment after the money increase and the long-run, the currency is appreciating due to the lower interest rate, and because of this period of depreciation, the currency must initially depreciate “too much.” (b) A monetary decrease of x percent will cause an appreciation of x percent in the long-run, but initially the appreciation will exceed x percent. (6) The model can be used to explain why exchange rates are volatile. ((7) The model can be used to explain why tight money raises the value of a currency and loose money reduces its immediate value.

Problems. (a) The model uses a large stash of assumptions.

7. Bank runs/firesale. Main features: (1) The expectation of a run can cause a run.(2) Raising capital requirements can reduce the instability of the model. That is, with low capital (reserve) requirements, there might be two equilibria (instability), whereas with high capital requirements there might be only one equilibrium (stability). (3) Discount lending, or emergency IMF-type lending might be socially desirable.

Problems. (a) The model requires the assumption that the sale of an asset quickly (in a firesale) will cause its value to fall substantially.

8. Reserve Requirement Reflex. Main features: (1) Lending by banks is restricted by the real value of assets held (the capital or reserve requirement). A fall in the real value of assets held can reduce the amount that banks can lend. An exogenous increase in the real value can raise the amount that banks can lend. (2) An exogenous decrease in aggregate economic activity can generate, through a reduction in bank lending, a further reduction in economic activity (a mini slump can cause a larger slump). An exogenous increase in the real value of economic activity can generate, through an increase the ease with which banks can lend, an increase in economic activity (a mini positive shock can cause a large positive shock). Thus, bank reserve requirements create instability—excessive upward and downward changes in aggregate output. (3) This model suggests a reason for the Fed to exert counter-cyclical pressure.

Problems. (a) The model needs to be developed and made more clear and formal.

9. The Growth Model. Main features: (1) A set of feasibility conditions-(a) Output uses equal production: Y = C + I + G + NX, (b) This period’s capital less depreciation, plus investment is next period’s capital, (c) Total output Y is total production F(K,N,A), where K is capital, N is labor input and A is technological capability. (2) (a) Firms choose K and N to maximize profits. Firms take the rental price R (the user cost) of capital and the real wage w as given and beyond their control. (b) Individuals choose consumption, savings and labor input to maximize expected lifetime utility. They also take the rental rate of capital (which for them is the return on savings) and the real wage as given and fixed. (3) The equilibrium prices (R and w for each period t) are such that the decisions of the firms and the individuals are feasible (satisfy the feasibility conditions). (4) Some implications are: the real rate of interest is r = MPK – d, where d is the rate of depreciation. Also, r = r + g gc, where gc is the growth rate of consumption, r is the time rate of preference and g is a parameter from the utility function. (5) The long-run desired capital stock is proportional to the long-run level of technology A. When A is expected to increase, the long-run desired capital stock increases, and when A is not expected to increase, the long-run desired capital stock does not increase from its current level. (6) Current investment is determined by the how the current capital stock stands in relation to the long-run desired capital stock. When the desired level is well below current levels, investment is high; when it is at or below current levels, investment is low. (7) Current investment demand is a primary determinant of current labor input.

Problems. (a) The model has no money. (b) Individuals have infinite lives.

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